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How Did America Recover from the Great Depression?

Part II: Yes, Now is the Perfect Time to Talk Economic Recovery in America

Note: This post is one part of my series, Yes, Now is the Perfect Time to Talk Economic Recovery in America, which provides an in-depth look at the current economic crisis and how the United States will climb out of it. Click the link or scroll to the bottom to check out the other posts in the series.

Within a two year period, the United States claimed a decisive victory in World War I and put a ravaging Spanish flu pandemic in the rearview mirror. The next decade was fueled by renaissance. Young, American veterans added to a burgeoning manufacturing sector and business class. A frayed social scene bloomed into an era of decadence and cultural expression — filled with F. Scott Fitzgerald, flappers, and jazz. The “Roaring Twenties” rose like a crescendo, and then…it all came crashing down.

In late 1929, the stock market cratered as sell-offs swelled. Deemed “Black Thursday”, a Wall Street panic ensued and the Dow Jones Industrial Average fell 11%.

According to the Federal Reserve Bank of St. Louis, between 1929 and 1933, production declined by a third, the unemployment rate hit 25%, the stock market lost 80% of its value, and some 7,000 banks failed.

An economy in utter freefall created incredible devastation for the American worker, family, and way of life. Marred by breadlines, soup kitchens, and shantytowns, the 1930s were a painful time. The Great Depression rocked the nation, and the economy wouldn’t fully recover until World War II.

The Great Debate

The primary cause of the Great Depression remains a point of great intrigue and dispute. It was likely spurred by an amalgamation of factors: overspending, speculation, protectionist trade policy, and banking decentralization.

A panic, which is the worst case scenario for an economy, created a sudden and furious run on cash. Whatever the true root cause, or series of causes, the United States’ financial system was ill-equipped to respond to such a massive, market-wide sell-off. An elongated period of ruin followed.

With the panic, the public ran to pull their money out of investments and banks. However, banks, which normally only keep a fraction of liquid reserves, could not meet the demand. As the money supply dried, banks were also less willing to lend. They needed to keep as much cash on hand as possible.

In turn, this lack of credit caused production to decline and layoffs to soar. The prices of basic goods and services dropped, but people couldn’t afford to purchase them. Definitionally, the United States experienced massive deflation.

Keynes vs. Hayek

The Great Depression, and its global impact, sparked a nexus between economic theory and philosophical thought. Two economists, John Maynard Keynes and Friedrich Hayek, became the prevailing thought-leaders during this time. They offered differing views for the response mechanisms related to macroeconomic shocks. Most notably, they outlined a vision for a government’s role to right the ship.

Keynes, a British economist, asserted a new theory which proposed a check on the concept of free markets. He advocated for the idea that aggregate demand, or total spending, should include a government actor. This can be seen as the “G” below.

Primarily during times of crisis, private companies will spend less and produce less. In a downstream effect, individual laborers cannot find work because it no longer exists. There is a new, lowered employment ceiling and this spending bloc cannot contribute to aggregate demand in the way it previously could. In the aggregate demand formula, “C”, “I”, and “Nx” will all decrease.

Keynes argued that it is incumbent on a government, or “G”, to spend more and therefore balance the equation. A public-private partnership must fight the impulse to “save” during a downturn. Instead, a nation must “spend” to dig out. Otherwise, an economy will face prolonged and more permanent damage. He would advocate for direct, government spending, like a fiscal stimulus package or public works project. Keynes would also champion a strong central bank which keeps commercial banks solvent and ensures that they keep lending.

Conversely, Hayek offered a cautionary view related to government overreach. His basic argument asserts that economies experience natural “business cycles”.

Hayek believed that the flow of capital should not be drastically altered by an outside source; free markets and entrepreneurship will manage and government intervention should be exceedingly limited. In Europe, this is commonly known as austerity. He warns that a government, or strong central bank, can artificially bolster an economy only to create inflation.

Hayek developed his theory from both study and life experience. A native of Vienna, Hayek lived through a period of hyperinflation in Austria-Hungary. To pay its debts and improve a sluggish economy, the government increased the money supply and spending. Its neighbor, Germany, did the same.

While not specifically in his theory, Hayek warns about the perils of hyperinflation. As history notes, with a broken economy and dejection after World War I, these nations coalesced around fascism in its most brutal form.

Hayek underpins his theory on the inherent risk related to “spending your way out of a problem”.

You can make it worse.

The Solution

To recover from the Great Depression, President Franklin D. Roosevelt chose “Keynesian Economics”. Soon after taking office, he first focused on the banks and signed the Glass-Steagall Act. This legislation created basic guardrails to protect against speculation and ensure that adequate reserves were held.

Effectively, it separated commercial banks and investment banks. The former would deal in deposits and loans. The latter would deal in securities; instruments to raise capital in the form of equity and debt. The severing of these banks intended to protect homeowners’ savings from risky investing schemes. It would hold for nearly 70 years until the formation of financial holding companies (FHC) like Citigroup.

Glass-Steagall also created the Federal Deposit Insurance Corporation (FDIC). To protect individuals’ savings, all banks would now have to set aside a pooled allotment of money. The FDIC, an independent federal agency, would then manage these funds and gauge the financial health of these institutions. Individuals’ deposits were now insured. If their bank were to fail, citizens would get their money returned in full from the FDIC.

Lastly, Glass-Steagall created the Federal Open Market Committee (FOMC) which is the monetary policymaking body of the Federal Reserve System. This committee created a stronger central bank which would now sees its leaders meet regularly, review economic data, and vote on policy adjustments like setting long-term interest rates.

These banking reforms were just one component of President Roosevelt’s “New Deal”. He ushered in a wave of new programs aimed to protect the American worker. Some of the agencies still exist today. The Securities Exchange Committee (SEC) further checks Wall Street, the Social Security Administration (SSA) offers benefits to retirees and disabled individuals, and the Tennessee Valley Authority (TVA) provides regional economic development for an area hit particularly hard during the Great Depression.

The New Deal was a firm commitment by the federal government to spend on a massive scale in order to get the economy up-and-running. Just as it created millions of jobs, this initiative also injected cash directly into Americans’ hands. Within a few years, the United States’ economy was booming.

The New Deal’s effectiveness does merit fair criticism. After all, many of these programs were created in the mid 1930s and the economy did not revive until the early 1940s. Some economists believe that the formation of so many government programs reduced competition and actually exacerbated the problem. For instance, the Works Progress Administration (WPA) is widely considered a complete failure given the money spent and jobs produced.

The New Deal may have laid the foundation for American success in the decade to come, or it could have benefitted from an unforeseen event. On December 7th 1941, a day FDR proclaimed would live in infamy, the Japanese launched a surprise attack on Pearl Harbor.

The United States mobilized like never before; the economy hit new heights. By the end of World War II, America would realign the world order as the preeminent power of the Twentieth Century.

Thanks for reading! If you enjoyed this post please clap, share, and feel free to add me on LinkedIn to provide any feedback. For links to all of the other blog posts included in this series, see below:

  1. Yes, Now is the Perfect Time to Talk Economic Recovery in America
  2. How Did America Recover from the Great Depression?
  3. How Did America Recover from the Great Recession?
  4. The COVID-19 Recession Explained
  5. The First Relief Package Wave
  6. The Second Relief Package Wave
  7. The New Economy

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