The Great Depression was a worldwide event—few countries escaped its impact. The United States was not one of the first to experience the contraction but the contraction lasted longer there than in almost every other country. The recovery from the Great Depression in the United States was so slow that today it is common to think of the entire decade of the 1930s in the United States as the Great Depression. In fact, the incomplete recovery was interrupted by the 1937-1938 depression in the United States. What I’d like to do is make a few comments about the Great Depression of the 1930s in the United States and then use these to make a few observations about the current recession in the United States.
Although there are fewer and fewer people who actually lived through the Great Depression, I can remember my grandmother and her friends, who raised families during that decade, worrying, during the downturns of 1973 and 1981, that we would have another Great Depression. Even though the current contraction is not more severe than the contraction at the beginning of the 1980s, some commentators have conjectured that this one could turn into another Great Depression. So, let us take a brief step back and look at the Great Depression in the United States.
We must remember that until the First World War we, and most of the developed world, were on a gold standard.  That international monetary system worked reasonably well—not perfectly, but reasonably well. Between 1800 and 1900 the price level—according to the crude measures we have—actually declined slightly. However, during the First World War European nations abandoned the gold standard and printed fiat money to pursue their military objectives. International trade and domestic economies were dramatically disrupted and the allies relied on the United States for significant amounts of weapons and ammunition. These were purchased by selling their United States financial assets in U.S. markets, by borrowing in the United States and by selling their gold reserves to the United States. The United States was quickly transformed from an international debtor to an international creditor. Because of the huge inflow of gold the United States was able to remain on the gold standard and gold continued to circulate domestically. In 1914 the U.S. held about 26 percent of the world’s monetary gold stocks; in 1918 the U.S. held about 40 percent of the world’s monetary gold stocks. As a result of these changes prices rose in most countries—the United States as well as European nations.
After the war there was general agreement that the gold standard should be restored and many wanted the pre-war gold parities restored. However, two serious problems stood in the way of this. First, the United States held a much larger share of the world’s monetary gold than before the war. This would have required either dramatic changes in gold parities or a redistribution of gold away from the United States. Second, whether or not there was a redistribution of gold, the inflation during the war meant that there was not enough monetary gold to support the money stocks at the pre-war parities. To resume the gold standard at the pre-war parities would have required price deflation, particular for those European nations most directly involved in the war.
During discussions of what should be done, countries accepted floating exchange rates. The short boom after the war was followed by the short depression of 1920-1921 and officials in many countries became convinced that eliminating the economic instability required a return to a gold standard and fixed exchange rates. However it was obvious that the full pre-war gold standard could not be established so countries agreed to establish a “gold exchange” standard whereby the United States and Great Britain maintained sufficient gold reserves to back their currencies while other countries kept much, but not all, of their international reserves in the currencies of the United States and Great Britain. The idea was that they could always obtain gold from the United States or Great Britain if so required. To conserve gold for government use as a backing for the money supply and for international exchanges, most countries no longer allowed gold coins to circulate domestically. The United States was one of the few countries that continued to allow the domestic circulation of gold coins. The “gold exchange” standard was essentially a managed, fixed exchange rate that did not have the flexibility to adjust to changes like a true gold standard did.
Some European countries that had experienced less war inflation chose to undergo deflation and resume pre-war parities such as Sweden, the Netherlands, Denmark and Norway, while counties that had experienced more war inflation such as France, Belgium, Czechoslovakia, Italy and Portugal returned to gold at less than pre-war parities. Though Great Britain had experienced significant price inflation during the war, it decided to return to gold at the pre-war parity and did so in 1925. France stabilized its currency in 1926 and returned to a gold standard in 1928.
But Britain had an overvalued currency. To maintain its gold reserves, the Bank of England had to keep interest rates higher resulting in slower growth, less investment and higher unemployment rates. France, as it prepared to return to gold, had undervalued its currency and gold flowed into France. By 1927 France had about 9 percent of the world’s monetary gold, by 1929 about 17 percent and by 1931 about 22 percent. French laws largely eliminated open market operations and with a small discount market the gold was effectively sterilized and could not affect French prices. Thus the gold inflows and outflows did not have the effects that the rules of the gold standard said they should have had.
By the end of the 1920s the gold exchange standard—whether countries understood it or not—was facing a crisis. The United States and, primarily, France were accumulating more and more of the world’s monetary gold—at the expense of other countries. In 1927, for the second time in the 1920s, the Federal Reserve System turned to an expansionary monetary policy in an attempt to help Great Britain remain on the gold standard while obtaining France’s agreement to stop redeeming British pounds for gold. Speculation in the already booming American securities market accelerated and the U.S. lost gold. Concerned about the gold loss and the securities speculation, the Federal Reserve System reversed course and adopted a contractionary monetary policy. The gold losses ceased and gold flowed back into the United States. With France and the U.S. gaining gold at the expense of other countries, nations around the world adopted contractionary policies in attempts to stem the gold outflow. Thus, a worldwide contraction was initiated which arrived in the United States by the mid-summer of 1929.
Now stop and think about what an economic contraction superficially looks like. It appears that there is a combination of generally excessive production and inadequate demand. Unsold goods and materials begin to accumulate. Factories, machines and stores are idled and unemployment rises. A superficial assessment then would say that, “All we have to do is increase the general demand for products and services and we can end this contraction.” Or it might say, “All we have to do is reduce the excess production and spread the work and we can re-employ our resources.” President Herbert Hoover chose the first assessment and President Franklin Delano Roosevelt chose the second assessment.
But this is a fundamental misunderstanding of what has happened. There has been no loss of resources—land, mines, factories, machines, labor, skills, technology—those all still exist. Consumers’ desires for products and services have not diminished at all. The problem is that the system that coordinates all of this economic activity has been disrupted—the price system no longer is coordinating economic activity because something has disrupted the economy’s price system. Though other events can also cause this, the usual culprit is the monetary system. It is impossible to end such an economic contraction until relative prices can again begin to adjust to re-coordinate economic activity. If this is not allowed, then the contraction continues.
And this is true cause of the length and severity of the Great Depression in the United States from the mid-summer of 1929 through the first quarter of 1933. Consider some of the things that President Hoover did.  Hoover promoted the passage of the Agricultural Marketing Act authorizing the creation of a Federal Farm Board. With $100 million from the Treasury the Federal Farm Board made low interest loans to farm cooperatives to stabilize grain prices and support grain prices at higher levels. The Board also authorized the creation of corporations to purchase grain when grain prices were falling. The idea was to purchase when grain prices were lower and sell when prices rose and pay off the loans. But if target prices are set above levels that the national and international markets will bear then the cooperatives and corporations see only accumulating surpluses. Congress gave the FFB an additional $100 million in the spring of 1930. But finally the Federal Farm Board affiliates began selling their inventories depressing grain prices even further and worsening the depression in the agricultural sector.
To aid farmers Hoover had agreed to support a tariff bill but industry after industry pleaded for protection or added protection and the resulting Smoot-Hawley tariff sharply raised import duties on a massive list of items, again distorting prices and helping bring on a massive contraction in international trade—a contraction that severely impacted exporting firms just as it aided, to some extent, import-competing firms. Many argue that this was a major factor in the worldwide nature of the depression. Again this required adjustments in relative prices and significant shifts in resources.
Hoover’s troubling interference continued. In 1932 Hoover proposed that personal income tax rates be increased by extraordinary amounts—the top rate rose from 25 to 63 percent. A slew of new and restored taxes were also imposed on products and services to reduce the growing federal budget deficit. He proposed the Reconstruction Finance Corporation to invest in and lend to banks in an attempt to stabilize the struggling banking system—a proposal that came back to haunt his administration in the fall of 1932. 
The clearest example of Hoover’s misunderstanding of the price system is found in his handling of labor markets. Hoover had been appalled at the wage and price adjustments in the short, but severe, depression of 1920-1921, an event he described as “a liquidation of labor, stocks, farmers and real estate.” The depression ended before Secretary of Commerce Hoover’s conferences could address this but throughout the twenties Hoover preached a “high wage” policy and railed against the “liquidation of labor through wage rate cuts.” The worsening of the contraction, after the late October 1929 stock market crash, allowed Hoover to put his ideas to work. In early December he called leaders of industrial, construction and public utility firms to White House conferences to coordinate business and government agencies in order to minimize the contraction and keep it brief. In Hoover’s estimation wage rates had to be maintained in order for laborers to continue to spend. If wage rates had to be reduced at all, they should be reduced by no more than the cost of living. Any reductions in work hours should be accomplished by reducing the workweek rather than unemployment. Profits, rather than wage rates, should fall and, at the same time, firms should expand their investments. Public commitments were obtained from those business leaders to follow those guidelines.
The results were disastrous.  During the first two years of the depression large firms kept their wage rates almost constant, though some small firms began cutting wage rates. Large firms began laying off employees, cutting workweeks and allowing their profits to fall. Falling prices combined with rigid wage rates meant that real wage rates were increasing, thus raising real production costs. The result was that unemployment soared during 1930 and 1931 while profits plummeted. Faced with disastrous choices, in 1931 more and more large manufacturing firms began cutting wage rates, often over the objections of their leaders who had pledged to follow Hoover’s requests. By that time the falling wage rates were well behind the already falling prices creating greater disruptions in the price system. 
Prices began falling in late 1929 and would continue to fall through the first quarter of 1933 because of the Federal Reserve System. Created to be a lender of last resort to member commercial banks to stabilize the monetary system, the new laws no longer allowed those banks to partially cease or to limit deposit redemptions during periods of panic as was possible prior to 1913. But the Fed was unable to fully be a lender of last resort because it could lend only to member banks and only on short-term commercial loans (or commercial paper). Even then, the Fed was unwilling to do as much as it could have done. Regional and localized banking panics beginning in the fall of 1930 led to large numbers of bank failures and to defensive actions by the remaining banks. Banks that survived the panics, as well as most banks elsewhere, began reducing lending and increasing their reserves to protect against further bank runs. More and more consumers began holding more of their monetary assets in cash rather than in savings deposits in banks—banks that might fail. The rising reserve ratios and growth of non-bank cash holdings (which were potential bank reserves) led to a much larger reductions in demand deposit money. If the Fed had created enough reserves to offset this—as they were chartered to do—the money supply would not have fallen but they did not do this and banks no longer had the option of temporarily suspending deposit redemptions to stem the continuing banking crises.
The situation was even worse in the case of closed banks. When a bank closed the process of liquidation could take several years. During that time consumers and businesses that had deposits in the closed bank effectively lost those assets—and generally recovered only a fraction of the monetary assets at the close of liquidation. Facing a loss of savings consumers and businesses retrenched on their spending trying to restore some of their lost wealth. Businesses that had relied on the closed bank for lines of credit now had to go elsewhere—if lines of credit were even available elsewhere, which they often weren’t. As the money supply fell, spending fell. The result was that prices fell and, when wages finally began to fall, they were chasing the already falling prices. The rising real wage rates made it increasingly difficult for employers to hire or continue hiring workers and to continue producing.
Roosevelt’s banking holiday at the beginning of March 1933 as he assumed the Presidency—operating, it should be noted, much like an extreme case of banks temporarily suspending deposit redemptions as they had done in the pre-1913 era—stopped the contraction of the banking system and the money supply and brought some stability to the monetary system. With that markets began the adjustment of prices and resources and the recovery began. The Great Depression was over. But it’s length and depth is a tribute to the Hoover administration’s assumption that maintaining labor’s buying power and controlling prices were essential to controlling the contraction. This, in combination with the Federal Reserve System’s ineptitude, created the catastrophe that we call the Great Depression in the United States.
If President Roosevelt had done nothing else and had allowed markets to continue to adjust the United States might well have recovered from this severe depression in a couple of years.  But Roosevelt was elected with an agenda and his administration pursued it with a vengeance. They believed that unrestrained free markets had resulted in widespread “overproduction.” Their response was to propose The New Deal to cartelize American industry and agriculture, control prices and investment, spread the work and reduce production to eliminate overproduction—all under federal government oversight through the AAA (Agricultural Adjustment Act) and the industry codes promulgated by the NRA (National Recovery Administration). They also poured federal funds into government “make-work” programs to put people back to work doing “useful” government projects. Because NRA industry codes were not being developed rapidly enough, the administration requested that all industries submit to a general “blanket” code until each industry could develop its own code. The “blanket” code emphasized shortening the workweek and raising or stabilizing wages without regard for the type of industry, firm or location. The result was that this entire set of programs virtually stopped the infant recovery in its tracks by the end of 1933. Little recovery occurred from then until crucial New Deal programs were declared unconstitutional in mid 1935 and early 1936.
The recovery of the economy finally began to accelerate from late 1935 into early 1937 when new initiatives stopped it and brought on the 1937-1938 Depression. Roosevelt proposed and Congress passed large increases in personal income tax rates. Then they attempted to confiscate retained corporate profits through a new tax. The new Wagner Act brought in federal control to labor markets and was instrumental in sharp increases in wage rates without accompanying increases in productivity or demand. The Federal Reserve System, determined to reduce possible sources of inflation, doubled reserve requirements to wipe out most of banks’ excess reserves. Banks responded by reducing lending to restore excess reserves causing the money supply to fall exacerbating the contraction. And the 1937-1938 “depression within a depression” was created. The entire period from 1934 through 1941 was one of economic misery caused by the Roosevelt administration’s misguided attempts to solve the depression by reducing private production and by government control of the American economy.
Contrary to what many still believe the Second World War did not bring the United States out of the depression. It is easy to eliminate unemployment if the federal government conscripts into the armed services more men than were unemployed before the war began. With prices controlled and production directed from Washington, D. C., inflation was hidden and superficially things looked better. But private investment, even including investment for military production, declined sharply during the war and consumers actually consumed less goods and services because of price controls and rationing. Once the war ended and the economy was freed from price controls and rationing, markets responded as businesses invested and re-employed people and consumers shopped for what they wanted when they wanted—and the recovery actually commenced. 
The Great Depression and the depression like recovery during 1934-1941 are not testimony to the instability and inadequacy of free markets. Rather they are tragic testimonials to the harm misguided government interference can do and to the damage that money manipulation can bring about.
Now, let me briefly turn to the current recession and make a few observations. I begin with my argument that this recession is not due to any malfeasance and/or incompetence of financial firms in the United States. Please note that I am not absolving financial firms of any role in this or of their actions. But the sources of this contraction do not lie in the private sector.
Following the terrorist attacks of September 11, 2001 the Federal Reserve System began reducing the target federal funds rate by pumping reserves into the banking system. The target rate, which had been 6 percent at the beginning of 2001, was reduced to 1.75 percent by December 2001, 1 percent by the middle of 2003 and stayed there through early 2004 when the Fed began to gradually raise it back toward 5 percent in early 2006.
This expansionary monetary policy is premised on banks lending out the new reserves the Fed is pumping into the banking system. To do that, banks reduce rates on loans encouraging new borrowers and the Fed was clearly pleading with the banks to do exactly that. It is primarily investors who borrow this new money and the investment sector that responds the most and the quickest to changes in interest rates is the housing sector. Therefore, exactly as should have been predicted, the monetary policy initiated a huge expansion in the housing sector. The very low rates set off a huge increase in the demand for existing and new housing. Housing prices began to rise in response and housing construction expanded pulling more and more resources into the sector. If you go back and read newspaper and magazine articles about the United States during 2002, 2003 and 2004 you will find continual references to “the strength of the housing sector—the one bright spot in investment and overall economic activity” during that period. But that should hardly have been surprising given the monetary policy.
What would one expect the banking sector to do in the face of this Fed impetus? One would expect lenders to reduce rates, reduce down payments on housing loans, develop new “creative” ways to make loans and to make riskier loans because this was the easiest way to get the new money out into the economy—the easiest way to accomplish the Federal Reserve System’s objective. Certainly some, if possibly not much, of the fraud that occurred came about because the Federal Reserve System’s very easy monetary policy made it so easy for the fraud to take place.
Why did the Federal Reserve System keep interest rates so low for so long? Remember, the target federal funds rate was one percent or less for nearly two and a half years. I contend it was because the recovery—beyond the housing sector—was much slower than what the Fed wanted or expected. Thus they continued to use the only tool they had—low interest rates and an expanding money supply—to try to expand economic activity. But remember, a contraction is not simply inadequate demand; it comes about because something disrupts the price system.
In this case it was the terrorist attacks and the consequent adjustments to the terrorist attacks and to the threat of future attacks. The airline industry had been experiencing difficulty since the spring of 2001 and was in serious trouble after the attacks. Travelers’ destinations were dramatically altered, choices were changed because of the threat of terrorists, and governments in the wake of those attacks imposed new demands. All of these required a multitude of adjustments in prices and resource allocations. But monetary policy is not designed to facilitate such adjustments; it is designed to increase demand through, primarily, increased investment. The most likely effect of such expansionary policies would be to delay and make more difficult the price and resource adjustments that are required. Thus, the recovery was longer than it would have been without the expansionary monetary policy! That’s why the target federal funds rate was kept so low for so long. 
But all good things must come to an end. If the Federal Reserve System had kept pumping reserves into the banking system to keep interest rates low, it would have unleashed accelerating price inflation—that would have been inevitable. Thus, from early 2004 to early 2006 the Fed increased the target federal funds rate to a more normal 5 percent. This increase spelled the end of the housing bubble the Fed had created. Higher rates began reducing consumer demand for housing and following that housing prices began to decline. Rising mortgage rates raised monthly mortgage payments and some homeowners found that they could not make those payments. Low introductory rates—or “teaser” rates—jumped to higher normal rates and some borrowers found that they could no longer make the payments. People who had bought properties for speculation because of the rising housing prices found that the properties’ values fell rather than rose and were stuck with unwanted properties. The demand for new housing declined and the housing construction industry found itself with idled resources and unemployed workers. And, as would be expected, the decline in their demands began to make its way through the economic system. Lenders were in trouble and some of the innovations in securities fostered by the Fed’s low interest rate policy became a ticking time bomb. That time bomb exploded in the fall of 2008.
But the source of the problem was not in the innovative securities—good as well as bad—not in the malfeasance of some lenders, not in the new types of mortgages. The source of the problem lay in the Federal Reserve System’s attempt to stimulate economic activity by keeping interest rates extraordinarily low for a very long period of time; an attempt that was largely futile because it did not address the underlying causes of the 2001 recession.  The Fed is once again using an expansionary monetary policy in an attempt to stimulate the economy, And it is already beginning to worry about how to withdraw those additional reserves pumped into the banking system—in order to not ignite price inflation—without causing a new crisis in the banking sector.
I cannot conclude without a few comments on the federal government’s responses to this recession. Clearly, little has been learned in the years since the Great Depression. Blinded by their Keynesian spectacles, both the Bush and the Obama administrations concluded that the problem simply lies in inadequate demand, “so let us stimulate demand through federal government stimulus programs.” Let me be clear, this is not a Democrat or Republican problem; it is a problem of government and politics and the fundamentally flawed Keynesian macroeconomic theory behind these programs.
They expected to stimulate the recovery by gigantic increases in federal spending. To do this they funneled billions of dollars to state and local governments as well as directly increasing spending on federal projects. States, counties, cities, villages, and public school districts all rushed to find “worthwhile” projects to attract “their share” of the federal stimulus money. But I think we’ve seen this before. There are echoes of the PWA, the WPA, the CCC, the other New Deal “alphabet” programs and the potpourri of government make-work programs of the 1930s.
The federal government has decided to “bailout” failing banks and failing companies such as AIG, GM and Chrysler. In this there are echoes of the 1930s RFC—Reconstruction Finance Corporation—a Hoover creation that was continued by Roosevelt. But, in the 1930s they primarily lent to banks and let the other companies face their fortunes in the markets—not like the bailouts, takeovers and destruction of bondholders’ property rights that has occurred since last fall.
And now we’re in the midst of an ongoing bitter discussion about creating some kind of national healthcare program—a government run program to control the costs and operations of the healthcare sector. In this case the recession simply provided a convenient opportunity to expand the scope of federal government control in this area—something the Democratic party had long coveted. But in this we again hear echoes of the 1930s, of Roosevelt’s New Deal programs to cartelize American industry because they believed “unregulated competitive markets had brought on the depression;” “because we could no longer trust free markets to act in the best interests of the American people.” We hear echoes of the Wagner Act, the Minimum Wage Act and of the Social Security Act—all fundamentally flawed legislative acts. Like today, those programs were proposed not to cure the depression but to reform the American economy under the control of the federal government.
Finally, there is nothing in these current government stimulus programs that addresses the true cause of the recession. The recession did not come about because of inadequate aggregate demand. It did not come about because of the fraudulent activities of some financial firms. It did not come about because the mistakes of the private sector led to a housing bubble. It came about because monetary mismanagement led to disruptions in the price system that could not be sustained. Artificially low interest rates led to rising housing prices and a boom in housing construction. The prices of housing construction and materials for housing construction rose to draw more resources into the housing industry. It led to more activity for financial firms and more resources there, to new types of financial instruments based on mortgages and countless other relative price changes and resource movements. The Federal Reserve System created a housing bubble that had to burst when the Fed stopped pumping reserves into the banking system and allowed interest rates to rise to a more normal level.
None of the government programs mention this. None of the government programs address an attempt to let relative prices adjust so that they can once again coordinate economic activity at something approaching full-employment. Most of the programs, in fact, are designed to stop those price adjustments—to keep the status quo.
So, I end this on a rather somber note. Markets will adjust in time as long as we don’t socialize most of the American economy. But the Federal Reserve System’s actions and the stimulus programs of the federal government will only retard the recovery and make it slower than it would have been. We can only hope that they are not nearly as good at this retardation as the federal government’s programs of the 1930s were.
Gene Smiley is currently a Professor Emeritus of Economics at Marquette University.
The lecture was presented at the Conservative Economic Quarterly Lecture Series (CEQLS) held by the Conservative Institute of M. R. ©tefánik in Bratislava on November 23, 2009.
The lecture is available also as a video here.
 Most of this information is drawn from Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 (New York, 1992), though my interpretation of the data is clearly different from Prof. Eichengreen’s. Relevant information is also found in Peter Temin, Lessons from the Great Depression (Cambridge, MA, 1989) and David Glasner, Free Banking and Monetary Reform (New York, 1989).
 These points are discussed in more detail in Gene Smiley, Rethinking the Great Depression (Chicago, 2002).
 Democrats, led by John Nance Garner, insisted that Congress begin publishing the names of banks that received RFC loans and began releasing the names of borrowing banks in the late summer of 1932. This appears to have increased consumer anxiety and increased withdrawals from banks accelerating the banking crisis that began in late 1932. For a discussion of this see, Richard H. Keehn and Gene Smiley, “U.S. Bank Failures, 1932-1933: A Provisional Analysis.” Essays in Business and Economic History, Vol. 6 (1988), pp. 136-156.
 For an extended discussion of this see Richard K. Vedder and Lowell E. Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America, Updated edition (New York, 1997), primarily chapter 5.
 For a discussion of this see Smiley, Rethinking the Great Depression, pp. 59-63.
 Vedder and Gallaway suggest that a rapid recovery might have ensued without the New Deal. Michael Darby believed that by 1937 something approaching full-employment might have occurred if there had been no 1937-1938 Depression. See Michael Darby, “Three-and-a-Half Million Employees Have Been Mislaid: Or, An Explanation of Unemployment, 1934-1941,” Journal of Political Economy, 84 (Feb., 1976), pp. 1-16. I think that full-employment might have come even sooner without the government’s interference as happened in the recovery from the 1920-1921 Depression.
 See Vedder and Gallaway, Chapter 8, for an extensive discussion of this as well as other sources of this conclusion.
 Prominent macroeconomist John B. Taylor, a former senior economist to and member of the President’s of Council of Economic Advisors, and developer of the “Taylor Rule” to guide monetary policy has also argued this in Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Stanford, CA, 2009). However, Taylor’s rule would still have reduced rates sharply in 2001 but then would have began raising them back toward a more normal level (5 percent) after the beginning of 2002. He is still a proponent of an activist monetary policy.
 Thomas Sowell has argued that the housing boom and bust was caused by government interference but he pinpoints many different local governments (particularly on the coasts and in larger cities) with causing the problems. Controls and restrictions reduced the ability to invest in new housing causing housing prices to rise sharply in those areas and new innovative mortgage packages to be developed and lax lending standards to be imposed to allow buyers to purchase houses at the much higher prices. Thus, the housing boom and, particularly, bust varied across the United States and was far from the same everywhere. The bust occurred when the Fed began to nudge interest rates back toward a more normal level in 2004 causing the lax lending standards to implode. See Thomas Sowell, The Housing Boom and Bust (New York, 2009).