Causes of the Great Depression: What Triggered the Collapse

The Great Depression was the worst economic crisis in American history. It was not caused by a single event. It was the product of structural weaknesses that had been building through the 1920s, an immediate trigger in October 1929, and a series of policy mistakes that turned a severe recession into a decade-long catastrophe. For the larger arc, see the parent end of the Roaring Twenties; for the human consequences, ; and for the year-by-year chronology,

The Stock Market Crash as Trigger

The immediate trigger of the Great Depression was the stock market crash of October 1929. Between 1921 and 1929, the Dow Jones Industrial Average had risen by almost 500 percent — far faster than the growth of corporate earnings. By September 1929, the average stock on the New York Stock Exchange traded at roughly 30 times its earnings. The market was a bubble, and bubbles always pop. The story of the actual crash is told in our stock market crash of 1929 coverage and in detail on the Black Tuesday page.

But the crash alone did not cause the Great Depression. The economy continued to grow through the first half of 1930, and most economists expected a normal recovery. The deeper crisis was caused by four other factors: structural weaknesses in the economy, monetary policy mistakes, the Smoot-Hawley Tariff, and the international banking crisis.

Structural Weaknesses in the 1920s Economy

Income inequality in 1929 was at historic highs. The top 1 percent of American families received about 19 percent of all income, and the top 5 percent received about 30 percent. The result was that the consumer economy depended on a relatively small wealthy class to buy a large share of the new durable goods. The agricultural depression had begun in 1920 and never really ended. Per-capita farm income in 1929 was less than half the 1919 figure. The collapse of the agricultural economy had been masked by the urban boom, but the rural banking system had been failing in waves through the 1920s.

Overproduction in industry was the third weakness. The new mass-production techniques had made the consumer-goods market saturated. By 1928, the demand for new automobiles, radios, and household appliances was beginning to soften. Consumer debt was the fourth weakness. The 1920s had invented modern installment credit, and by 1929 American households owed roughly $6 billion in installment debt — a sum larger than the federal budget. The debt was manageable in good times but vulnerable to any interruption of income. The story of the 1920s consumer credit economy and its collapse is told in our consumer culture coverage and the rise of consumer credit in the 1920s.

The Federal Reserve’s Mistakes

The single most important policy failure of the early 1930s was the Federal Reserve’s mishandling of the banking crisis. The Federal Reserve had been led during the 1920s by Benjamin Strong, the influential head of the Federal Reserve Bank of New York. Strong died in October 1928, and the Federal Reserve was left without effective leadership at the worst possible moment. His successor, George Harrison, was a much less influential figure, and the Board in Washington was dominated by Roy Young, a former railroad executive.

In 1928 and 1929, the Fed had raised interest rates in an effort to slow the speculative bubble. The rate increases had the unintended effect of making money tight even as the economy was slowing, and the rate increases were continued into 1930 and 1931. When the bank failures began in October 1930, the Federal Reserve’s job was to act as a lender of last resort. The Federal Reserve largely failed to do this. Between 1930 and 1933, more than 9,000 American banks failed, and the money supply contracted by about 30 percent. The work of Milton Friedman and Anna Jacobson Schwartz in their 1963 book A Monetary History of the United States is the most influential modern account of the Fed’s failure.

The Smoot-Hawley Tariff

The second great policy mistake was the Smoot-Hawley Tariff Act, signed by President Herbert Hoover on June 17, 1930. The act raised tariffs on more than 20,000 imported goods to record levels, intended to protect American farmers and manufacturers from foreign competition, but it set off a wave of retaliation. By 1933, more than two dozen countries had adopted retaliatory tariffs, and world trade had collapsed by about 65 percent between 1929 and 1934. American exports fell by nearly 70 percent.

The Gold Standard and the International Crisis

The third great policy mistake was the international commitment to the gold standard. Under the gold standard, every major currency was convertible into a fixed weight of gold. The constraint was that countries could not devalue their currency to make their exports cheaper, and they could not expand their money supply. In 1925, Winston Churchill, then the British Chancellor of the Exchequer, had returned Britain to the gold standard at the prewar parity, a move that overvalued the pound and hurt British industry. The gold standard forced countries to keep interest rates high in 1930 and 1931, even as the depression was deepening.

The international crisis was aggravated by the Dawes Plan of 1924 and the Young Plan of 1929, which had set the schedule for German reparations payments. The collapse of the German financial system in 1931 — the Creditanstalt crisis in Austria in May, the Danat-Bank crisis in Germany in July — turned an American recession into a world depression. Britain left the gold standard in September 1931; the United States would not leave until March 1933.

The Bank Failures

The fourth great failure was the banking system itself. The 1920s banking system was a unit banking system of more than 25,000 commercial banks, and there was no federal deposit insurance until 1933. The first major bank failures occurred in October 1930, when a run on the Bank of Tennessee in Nashville spread to other banks. By the end of 1930, more than 1,300 banks had failed. By the end of 1932, almost 5,400 had failed. By the time the new Federal Deposit Insurance Corporation (FDIC) was created in June 1933, the cumulative total was more than 9,000 — a contraction of more than a third of the country’s banks in less than three years. The contraction of the money supply is the single most important mechanism by which the recession became the depression.

The Modern Consensus

The causes of the Great Depression are still debated, but the modern consensus is that the depression was the result of multiple failures that converged at once. The structural weaknesses of the 1920s economy made it fragile. The stock market crash was the trigger. The Smoot-Hawley Tariff, the Federal Reserve’s mistakes, the international commitment to the gold standard, and the cascade of bank failures turned the crash into a depression. The debt-deflation view of the economist Irving Fisher and the Keynesian view of John Maynard Keynes are important complements to the Friedman-Schwartz monetary account. The most likely truth is that all of these factors contributed. The policy lessons — that central banks must act as lenders of last resort, that fiscal stimulus is essential in a depression, that international economic cooperation matters — remain the bedrock of modern macroeconomics. To see the political consequences, see our coverage of Hoover’s response to the depression.