What Caused the Great Depression?

Economists disagree on what caused the Great Depression. The 1929 stock market crash was only one factor. Another factor was protectionist trade policies and the collapse of international trade. A tariff enacted in 1930 increased the cost of imported goods. Trading partners of the United States reacted by imposing their own taxes on American imports. The “prosperity” of the 1920s—overproduction of commodities, excessive building, financial speculation, poor distribution of income and wealth—also contributed to the economic crisis.

One central cause of the Great Depression was the collapse of the U.S. banking system and resulting shrinking of the nation’s money supply.

Money, Banking and Deflation

Money makes the economy function. Modern economies tend to break down when the quantity or value of money changes suddenly. Print too much money, and prices rise (inflation). Shrink the money supply, and prices fall (deflation).

In modern economies, the majority of the money supply is found in bank deposits, which are created when banks make loans. The Federal Reserve System regulates the amount of loans that banks can make by controlling the amount of reserves that banks must hold against their deposits. The bank management also makes decisions within these limitations.

U.S. bank reserves consist of the cash that banks keep in their vaults and the deposits they keep at Federal Reserve banks. Reserves earn little interest, so banks don’t like to hold too much money in reserve. Yet without sufficient reserves, banks risk trouble if there is a run of depositors making unexpected withdrawals.

In the 1930s, the United States based its monetary system on the gold standard. This means that the U.S. government would exchange dollars for gold at a fixed price. Both commercial and Federal Reserve banks were required by law to hold a portion of their reserves in the form of gold bullion.

If there was an increase in gold reserves, banks could increase their lending, which might inflate the money supply. A decrease in reserves, on the other hand, would tend to shrink the money supply.

At the start of the Great Depression, public panic and loss of confidence in the banks led to a fall in the money supply. Loss of depositor confidence in the ability to access their funds in banks whenever they need led people to withdraw their deposits to avoid losing their funds if their bank fails.

A sudden, unexpected attempt to withdraw deposits for cash can leave banks short of reserves. During the Great Depression, many banks were caught short. They could not borrow from the Federal Reserve because they lacked acceptable collateral or weren’t members of the Federal Reserve System.

In 1930, the U.S. financial system suffered a series of banking panics. Depositors withdrew saving. Banks lost reserves and had to reduce their loans and deposits. The nation’s money supply shrank. As banks failed, the economy collapsed.

Source: The Great Depression: An Overview
Courtesy of Federal Reserve Bank of St. Louis