Which Economic Theory Best Explains the Onset, Prolongation, and Demise of the Great Depression
The research methodology was to find
the one economic theory that best satisfied the primary cause of the Great
Depression: the role of the Federal Reserve, the propagation mechanism, why the
depression was prolonged, what ended the depression, and the best policy
prescription to account for recovery. By incorporating primary archives and publications,
and secondary analysis sources suited to qualitative policy research, this
paper arrived at the decision that the Keynesian Economic Theory best suited
those parameters. The research involved the following economic theories: the
Keynesian theory by John Maynard Keynes, the Austrian theory by Ludwig von
Mises and Friedrich Hayek, and the Monetarist theory by Milton Friedman and
Anna Schwartz.
The Keynesian theory states that underproduction
and demand failure are the result of a chain reaction of events. When aggregate
demand falls short of production capacity, production slows as a result, and
unemployment rises. The rise in unemployment exacerbates the fall in demand
because of the lack of wages, and the cycle continues to repeat unless there is
rapid self-correction through flexible markets. During
this period, inflexibility in wages, prices, and interest rates in the United
States contributed to widespread public pessimism, banking crises, and
persistent wage-price imbalances, resulting in the onset of the Great
Depression. The Keynesian theory places little value on the role of the Federal
Reserve, contending that the issue was demand failure, not excessive expansion.
According to the theory, the propagation mechanism was involuntary unemployment
and the paradox of thrift (public consumption dropped because people became thriftier
and concentrated more on saving rather than spending). The theory further
explains that the Great Depression was prolonged because of a lack of
sufficient fiscal stimulus caused by policy errors like balanced budgets. The
theory’s remedial action calls for expansionary fiscal policies through deficit
spending and public works. Ultimately, World War II’s massive deficit spending
invigorated the economy and ended the Great Depression.
The Austrian theory places the blame
for the onset of the Great Depression on the unsustainable 1920s boom from
central bank credit expansion and low interest rates, creating malinvestment
that led to the inevitable bust (the Great Depression). The Austrian theory contends
that the Federal Reserve allowed excessively easy money, which distorted the
capital structure and fueled the asset boom. The Austrian theorists believe
that the propagation mechanism was the lack of action to liquidate
malinvestments, causing fiscal adjustment delays. Contrary to the Keynesian
theory, the Austrian theory contends that the New Deal interventions propped up
bad investments and created even greater uncertainty. The Austrian theorists
also believe that a policy of hands-off, allowing bad investments to fail,
ending interventions, and the role of wartime production corrected the market
and ended the Great Depression.
The Monetarist theory places the
blame on the Federal Reserve’s passive failure to prevent a money supply
collapse, exacerbating the conditions in the Keynesian and Austrian theories of
the Great Depression’s primary cause. According to
the theory, while the Federal Reserve’s credit easing contributed to
instability, its primary mistake occurred after the 1929 crash when it failed
to address a 30% reduction in the money supply. Monetarists believe the
propagation mechanism was money and stock contraction, causing deflation, which
resulted in falling prices and output. They also contend that the lack of Federal
Reserve action worsened banking panics. The theorists believe that continued
tight money through 1933 and policy errors contributed to the prolongation of
the Great Depression. The Monetary theorists conclude that a policy of steady
money supply growth through post-1933 gold inflows and President Roosevelt’s
decision to devalue the dollar led to recovery.
In conclusion, all
three economic theories provide insight and viable explanations for the onset. prolongation
and the demise of the Great Depression. Constraints on money, market
fluctuations, deflation, and the Federal Reserve all played important roles in
the event, but they all led to the same conclusion. Private production activity
was greater than the public’s consumption capacity. When producers cannot sell
their goods, they must cut back on production, which leads to rising
unemployment, which in turn further reduces the public’s ability to buy. This
cycle was exacerbated by a variety of issues, but overproduction leading to an
output gap and the resulting unemployment are harbingers of economic collapse. There
is little argument that the Great Depression did not truly end until World War II
forced the American government into a sustained, long-term, massive fiscal
expansion. The public’s purchasing power was augmented by the government, leading
to a sharp rise in aggregate demand, eliminating the output gap. The Keynesian
economic theory satisfies more components of the research question than the
Austrian or Monetarist theories.
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