Opinion Editorial | |
| Friday, October 29, 1999 | |
What Caused The '29 Crash And Great Depression? |
Today marks the 70th anniversary of the stock market crash of 1929. Despite the passage of so many years, however, there is still no consensus on what caused the crash or the relationship between the crash and the Great Depression. These are still important questions because many of the factors that have been suggested as causing the crash and subsequent depression are still relevant today.
One of the most hotly debated causes of the crash is the Smoot-Hawley tariff. Protectionists like Alfred Eckes and Pat Buchanan argue that it could not have affected the market because the law was not passed until 1930, long after the crash. Although this is true, much of the legislative activity took place in 1929. As economist Alan Reynolds convincingly demonstrated in National Review (November 9, 1979), actions favoring passage of the tariff bill correlate quite well with declines in the stock market during 1929, culminating on October 29.
The reason why the market crashed well in advance of the tariff becoming law is because markets are forward-looking, and quickly capitalize any policy that will impact on future profits. Fred Kent, Director of the Bankers' Trust Company, confirms that this is what happened in 1929. In a speech on November 11, 1929, Kent said, "As soon as dealers in securities, who were constantly on the watch for indications as to business conditions, realized that this feeling of uneasiness (on account of the tariff bill) was spreading throughout industry, they began selling stocks."
What is less clear is the impact of the tariff on the real economy. According to the National Bureau of Economic Research, the initial economic decline of the Great Depression began in August 1929, well in advance of the stock market crash or Smoot-Hawley. While it is true that international trade collapsed after 1929, it is difficult to say how much was due to the tariff or the depression.
On one side of the debate are economists Barry Eichengreen and Mario Crucini, who argue that Smoot-Hawley's impact on the economy was negligible and possibly even expansionary. Writing in Research in Economic History (1989), Eichengreen says, "Contrary to the presumption informing most analyses of the subject, holding constant both the impact of Smoot-Hawley on the rest of the world and feedbacks to the United States, the direct effect of the tariff on the U.S. economy is likely to have been expansionary." Crucini, writing in the American Economic Review (June 1994), agrees, concluding that "the Hawley-Smoot Tariff Act of 1930 did not have the massive deflationary implications that are widely attributed to it."
On the other side of the debate are economists Douglas Irwin, Judith McDonald, Patrick O'Brien and Colleen Callahan. Irwin, whose research appears in the Review of Economics and Statistics (May 1998), argues that because many of the tariff increases were specific monetary amounts, deflation had the effect of increasing their real effect by 30 percent. Consequently, he concludes that Smoot-Hawley was responsible for at least 40 percent of the decline in imports after 1930.
Another important, yet neglected, impact of Smoot-Hawley was on foreign countries that retaliated against U.S. goods with tariffs of their own. McDonald, O'Brien and Callahan, writing in the Journal of Economic History (December 1997) convincingly demonstrate that at least in the case of Canada, then as now America's largest trading partner, tariffs were raised directly in response to Smoot-Hawley.
Interestingly, in a subsequent article in the Journal of Monetary Economics (December 1996), Mr. Crucini, who earlier had found little impact from Smoot-Hawley, changed his mind. Writing with economist James Kahn, he concluded that the impact of Smoot-Hawley was magnified by its effect on capital goods and imports of business inputs. Thus, in contrast to his earlier conclusion, Mr. Crucini now believes that Smoot-Hawley did precipitate a sharp decline in world trade and the U.S. economy.
Even taking the largest reasonable estimate of the impact of Smoot-Hawley, however, it could not by itself be responsible for the length or depth of the Great Depression. After all, the Fordney-McCumber Tariff of 1922 was as large as Smoot-Hawley without having any significant impact on economic growth. Also, Smoot-Hawley was substantially undercut by the Reciprocal Trade Agreements Act of 1934. The length and severity of the Great Depression, I believe, primarily resulted from a disastrous monetary policy by the Federal Reserve.
A key reason for the Fed's error was an over-reliance on low inflation as the main indicator of the correctness of monetary policy. As Murray Rothbard documents in "America's Great Depression" (1963), there was almost universal support among economists and policymakers in the 1920s for a Fed policy that targeted the price level. In other words, if inflation was low then per se this was proof that Fed policy was correct. But stable prices could disguise underlying economic imbalances resulting from incorrect Fed policy. Today, of course, inflation is also low and many in Congress, such as Senator Connie Mack (R-Fla.), believe that the Fed should be required by law to target only the price level.
Studies of monetary policy in the 1920s and 1930s now generally agree that Fed policy was too easy during most of the 1920s, turned sharply tighter in the late 1920s, and remained tight throughout the 1930s until World War II. Gold inflows in the 1920s expanded the money supply, but did not raise the general price level because the money was channeled into securities markets, where it fueled a stock market boom. In early 1928, the Federal Reserve became alarmed by the stock market boom, fearing that it was an unsustainable "bubble", and it moved to tighten money. In 1929, the Fed sharped its attack on "speculation" and tightened money further.
Writing in the American Economic Review (March 1984), economist Alexander Field showed a very close correlation between a tightening Fed policy in the late 1920s and the subsequent economic slowdown. He concludes: "This deflationary impulse, larger than is apparent from a simple examination of monetary growth figures in relation to GNP [gross domestic product] growth, was the proximate cause of the downturn in real activity generally dated from August 1929."
A key reason for the change in Fed policy in 1928 was the death of Benjamin Strong, president of the Federal Reserve Bank of New York. He was the Alan Greenspan of his day, whose influence over Federal Reserve policy was virtually absolute from the beginning of the Federal Reserve system in 1914 to his death. As long as he lived, the system worked tolerably well. But once he was gone, the Fed was virtually leaderless, which contributed to the massive contraction of the money supply by one-third between 1929 and 1933. One cannot help wonder how much the Fed today depends on the continued good health of Greenspan, and whether the system is really prepared to cope with his exit from the Fed for whatever reason.
Of course, there are many other factors that contributed to the length and severity of the Great Depression. Taxes were sharply raised in 1932 and 1935, for example, and the New Deal also bred a maze of government regulations that impacted heavily on business confidence. But in the end, I am convinced that a protectionist trade policy in conjunction with mistaken Federal Reserve policies were the main factors that caused the U.S. economy to shrink by 27 percent between 1929 and 1933. The lesson of history, therefore, may be that we should be especially careful about making policy mistakes in these key areas.
Source: Bruce Bartlett (senior fellow, National Center for Policy Analysis), October 29, 1999.
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