Causes of the Great Depression include a reduction in consumer confidence and spending.
The Great Depression was an economic collapse that began in the United States in 1929 and spread across the globe, lasting for much of the 1930s. During the Great Depression, millions of Americans lost almost everything they had: their jobs, as the economy contracted; their investments, as the stock market plunged; and their savings, as bank after bank failed.
The Great Depression was the most severe economic crisis in U.S. history. And even before it had ended, journalists, historians, and especially economists were trying to put together the pieces to figure out what exactly had caused it.
Today, more than three-quarters of a century after the Great Depression began, its causes are still the subject of much debate.
Most economists believe that overall economic activity naturally cycles between expansion and contraction, periods of economic growth alternating with shorter recessions and depressions. In the 20th century, for example, the National Bureau of Economic Research records twenty different recessions in the U.S. economy.
If recessions are natural and inevitable parts of the business cycle, the real question is not "What caused the Great Depression?" but "What made the Great Depression unique; what made it great? Why was it so severe and so long-lasting?"
Early analysis of the Great Depression focused on the stock market crash of 1929 as the factor that set the great depression in motion and determined its severity. More recent analysts, however, tend to depict the stock market crash less as a cause and more as a symptom of the Great Depression, according to Encyclopedia Britannica.
For most of the 1920s, the stock market had been booming; stock prices had increased by a factor of four over the course of the decade, and buying into the market seemed like a surefire way to make money, even for people who weren't big-money investors. But by 1929, speculation had driven the market value of many stocks much higher than the intrinsic value that the stock certificates represented; in other words, there was a stock market bubble.
The market began to show signs of turning downward, and suddenly the eager investors lost confidence. The rush to sell on Black Thursday, October 24, 1929marked the beginning of a rapid decline in which the stock market lost a third of its value. On Black Thursday alone, investors lost $10 billion to $15 billion. And the market's downward trend continued for years. By 1933 it had lost about three-quarters of its value.
The market's initial plummet was accelerated by investors who had bought their stock "on the margin." This was a practice that allowed investors to buy stock on borrowed money, using the value of the stock itself as collateral.
Buying on the margin worked fine when the market was going up, but when it declined, banks asked the indebted investors to either put up more collateral (since their collateral, the stock itself, was now worth less) or to repay their loans immediately. To get the money to do one or the other, investors had no choice but to sell some of their stock; and as more and more people were forced to sell, the drop in market prices accelerated.
The economic downturn was well underway before the nation's banks began failing in waves. But even though bank failures weren't the first cause of the Great Depression, they certainly had an effect on its severity and length.
As banks began to call in the loans they had made to stock market speculators, many investors found it impossible to repay their debts. As the rate of default increased and the economic indicators continued to tumble, confidence in the banking sector as a whole began to erode.
Because bank deposits were not insured like they are now, a bank failure meant that all of its depositors would lose all of the money they had in their accounts. Men and women rushed to pull their savings out of faltering banks, which only increased the speed with which the banks collapsed. Many people lost their life savings when their local banks failed.
One of the key features of the Great Depression was the long lasting drop in aggregate demand, or consumer spending. The spending level was extremely low throughout the depression, and its inability to recover may explain more than any other single factor the length and severity of the Great Depression itself.
The low level of aggregate demand was in some ways a self-reinforcing condition. When demand for goods and services dropped, it left the nation's industries with the capacity to produce more than the people could actually afford to consume. This led to decreased production and high unemployment, which lowered consumer spending even more. The low level of spending led to double digit unemployment from 1929 until 1941, one of the best indicators of the human toll of the depression.
There are a number of theories that attempt to explain why consumer spending dropped, and why it didn't recover. Because the drop in consumer spending is often regarded as the single most important cause of the Great Depression, these theories can also be thought of as attempts to explain the origins of the Depression itself. Here are three very different explanations:
The stock market crash and its immediate aftershocks decreased people's purchasing power and gave them a dismal outlook on investments and credit, which influenced individual economic behavior in such a way that it led to the Great Depression.
The economic growth of the 1920s was unequally distributed, creating a structural problem in the economy well before the stock market crashed. Some groups of people, especially rural farmers and unskilled workers, were passed over by prosperity, and the country as a whole could not afford to buy enough to keep the factories humming, thus creating the low demand that the stock market crash further reduced.
The money supply, or the amount of currency in circulation, along with the deposits held in banks and other financial institutions, actually shrunk at the beginning of the Great Depression. This contraction in the money supply directly produced the sharp decline in the demand for goods and services, and the deflation of their prices. The money supply contraction was a result of the action (or lack of action) by the U.S. Federal Reserve.
There's no single answer. Economists and historians continue to study the Great Depression and to debate its causes and effects, developing sophisticated theories to explain the catastrophic events of the 1930s.
It may be worth noting, however, that the monetary explanation, which argues that the contraction of the money supply was responsible for the Great Depression, is particularly influential today, especially among economists like Ben Bernanke, current chairman of the Federal Reserve.