2000-2001 Essay Contest

Second Place Essay

Checks and Balances: Economic protections from another Great Depression

Sid Puram
Edina High School
Edina, Minnesota


It has generally been the fate of economic theory to run a losing race against the course of history, and never to have completed the analysis of one phase of economic development before another takes its place.1

Joan Robinson's words offer insight into major historic economic events. While the Great Depression will live on in American history, its comprehensive analysis appears to be far from complete. Bread lines stretching for miles, families living in cars, school children wearing ragged clothes—these images need no macro-economic review to be understood; however, the causes of the Great Depression and whether such destructive economic conditions could exist again are much more complicated questions. Ultimately, developments in monetary policy and economic structure, changes in international trade and globalization, and reform of economic policy and laws will prevent another Great Depression.

Unlike the Federal Reserve Board of the Depression era that not only failed to limit the skyrocketing inflation of the Roaring Twenties but also blundered passively through the rapid deflation of the Great Depression, today's FRB anticipates changes in price levels and stock market bubbles. As the 1920s stock market ballooned due to margin purchases, the FRB should have expected its eventual crash. Its failure to increase interest rates and halt such "irrational exuberance," along with inflation of over 60 percent from 1920-1929, allowed unchecked growth that could not be supported or maintained.2 Moreover, during the Great Depression, savers converted their checkable deposits to currency during "bank runs," forcing banks to call loans from customers who had expected large gains in the stock market. However, given the monetary losses in the desolate market, many of these investors went bankrupt and were unable to pay: 9,000 banks had no option but to close. The FRB's failure to decrease interest rates and expand the money supply discouraged investment and consumer spending, allowing the downward spiral to go unchecked. Today, however, the FRB uses economic indicators to detect price level changes and acts against stock market bubbles in advance.

The economic structure today is fundamentally stronger than that of the '20s and '30s because of its well-organized labor force. A large initial impact of the Depression was massive layoffs and wage cuts by employers. However, today's labor unions are a powerful political force that will not permit labor to be used as a cushion for national disaster as it was in 1929. This resistance to "wholesale firing of production workers" and wage cuts that proved to be one of the most significant blows to the 1929 economy will provide a necessary support to the modern economy that simply did not exist in pre-Depression times.3

Policymakers of the Great Depression also attempted to solve a 25 percent increase in unemployment,4 six point decline in consumer spending,5 and 30 percent reduction in farm prices6 through protectionist trade policies that magnified economic difficulties—a situation impossible to replicate today. Although 1,000 economists from 179 different institutions criticized the Smoot-Hawley Act in 1930 as an economic "injur[y] [to] the vast majority of our citizens," Herbert Hoover approved this infamous tariff, which increased ad valorem rates to over 40 percent and imposed a 100 percent tax on imported raw materials.7 This "last will and testament of the New Era's every man for himself ethic" deepened the Depression by shifting the aggregate supply curve to the left,8 and furthered the recessionary gap, unemployment and a decline in real GDP.9 With passage of the tariff, the United States entered into a trade war with Canada, Britain, Switzerland, France, Austria and 20 others.10 The trade war furthered the decline in U.S. exports and hindered growth in real GDP and aggregate demand, forcing net exports from $1.5 billion to 1905 levels of $253 million.11 Smoot-Hawley destroyed international trade and prevented the international economy from helping to solve the Depression. Today, however, similar protective tariffs [would] never exist. The North American Free Trade Agreement and the General Agreement on Tariffs and Trade both limit U.S. international tariffs, while institutions like the World Trade Organization promote free trade. Because of economic globalization, the disheartening Depression-era levels of international trade and domestic investment are unlikely to reappear within the United States.12

Perhaps the most significant outcome of the Great Depression is the economic legislation that was passed; laws regulating the stock market and banks, and policies providing economic stimulation have effectively destroyed chances of another Depression in America. Black Thursday, Oct, 24, 1929, was one of the darkest days of American history. Without regulation, individuals had invested their life savings in stocks bought on margin that lost the majority of their value, leaving many bankrupt. However, the Securities Act of 1933, Securities Exchange Act of 1934 and several technological improvements should prevent a recurrence. These acts reinvigorated investor confidence in the market while providing necessary regulation and oversight by requiring disclosure on new security issues, prohibiting insider trading and manipulation, and providing FRB authority to fix margin requirements.13 The Securities and Exchange Commission was established to enforce these acts along with fairness in investment.14 The SEC has been crucial in deterring corruption and manipulation in the securities market. Reforms also included the institution of circuit breakers to suspend trading when declines occurred too rapidly and the implementation of automatic stabilizers for the stock market. These technological additions should secure market stability and prevent a stock market crash, thereby mitigating the chance of another Depression.

New Deal remedies also included reform of the banking system to guarantee a steady supply of money and prevent unforeseen runs on banks. The Emergency Banking Act established new requirements for banks before lending money, expanded governmental authority over savings and loans, and provided for management of failed banks through the Reconstruction Finance Corp. The Banking Act of 1933 extended this precedent by establishing the Federal Deposit Insurance Corp. to insure all deposits up to $5,000.15 The Glass-Steagall Act was also passed to separate commercial and investment banking, thus limiting speculation by banks.16 These acts helped regulate hasty investment, loans and withdrawals while rejuvenating public confidence in the banking system. Perhaps most significant of the banking reforms was the abrogation of the gold standard in favor of a fiat currency.17 This allowed investor confidence to determine the value of the dollar and provided flexibility in the expansion and contraction of the money supply. Such freedom in currency is critical to modern economic stability.

Because of the fiscal policies used to stimulate the economy and because of the adoption of a Keynesian perspective for governmental action during recessions, another Great Depression is unlikely. During the Depression, various organizations like the Agricultural Adjustment Agency, Tennessee Valley Authority and Civilian Conservation Corps helped to stimulate growth. While some reforms like the AAA focused on containing supply to equalize quantity demanded and quantity supplied, others focused on increasing government deficit spending to create demand for goods and services. The cyclical nature of spending transformed relatively minimal government stimuli into substantial increases in real GDP, income and growth. Ultimately, large increases in deficit spending as part of preparation for World War II brought the country out of Depression. Today, such stimulating policies exist in many forms—President Bush's tax cut proposal is the most recent example of how modern economic systems stimulate their economies before negative growth sets in. Timely policy actions stave off economic declines and increase consumer spending before problems even arise, nipping them in the bud.

Despite the Depression's destructive toll on society, the educational and political benefits from this event are unquantifiable. Any economic system is susceptible to the macro business cycle; however, knowledgeable monetary policy, well-managed international trade and prudent economic reforms can ensure stability. Some financial analysts argue that the "New Economy"' will inevitably be "infected" with the virus of economic depression; nevertheless, given current economic policy, the United States appears to be prepared and vaccinated. The Great Depression is an unforgettable historical lesson that has shaped our society and its response to financial problems. As T.S. Eliot once said, "The historical sense involves a perception, not only of the pastness of the past, but of its presence."18

Endnotes

1. Bernstein, 21

2. Blum, 578

3. Rublowsky, 169

4. McConnell, 167

5. Goldston, 37

6. Goldston, 51

7. McElvaine, 83-84

8. The leftward shift in the aggregate supply curve was due to the drastic increase in the price of imported resources.

9. McElvaine, 83-84

10. Warren, 94

11. Warren, 96

12. Friedman, ii-iii, 4-5

13. Galbraith, 171

14. Werstein, 179

15. Boyer, 816

16. Blum, 625

17. Blum, 624

18. Bernstein, 207

Bibliography

Bernstein, Michael A. The Great Depression: Delayed Recovery and Economic Change in America, 1929-1939.Cambridge: Cambridge University Press, 1989.

Blum, John et al. The National Experience: A History of the United States. San Diego: Harcourt Brace Jovanovich, 1989.

Boyer, Paul S. et al. The Enduring Vision: A History of the American People. Lexington: D.C. Heath and Company, 1996.

Cole, Harold E. and Lee E. Ohanian. "The Great Depression From a Neoclassical Perspective." Quarterly Review. Vol.23, No.1. Federal Reserve Bank of Minneapolis, Winter 1999.

Fettig, David. "Something Unanticipated Happened: Telling some 'neo' stories about the Great Depressions of the 1930s."The Region. Federal Reserve Bank of Minneapolis, December 2000.

Friedman, Thomas. The Lexus and the Olive Tree. New York: Farrar Straus & Giroux, 2000.

Galbraith, John K. The Great Crash. Boston: Houghton Mifflin Co. 1972.

Goldston, Robert. The Great Depression. Indianapolis: The Bobbs-Merrill Co., Inc., 1968.

McConnell, Campbell R. and Stanley L. Brue. Economics: Principles, Problems, and Policies. New York: McGraw-Hill, Inc., 1996.

McElvaine, Robert S. The Great Depression: America, 1929-1941. New York: Times Books, 1961.

Prescott, Edward C. "Some Observations on the Great Depression." Quarterly Review. Vol. 23, No.1. Federal Reserve Bank of Minneapolis, Winter 1999.

Rublowsky, John. After the Crash: America in the Great Depression. Toronto: Crowell-Collier Press, 1970.

Schwartz, Jordan A. The Interregnum of Despair: Hoover, Congress, and the Depression. Urbana: University of Illinois Press, 1970.

Warren, Harris G. Herbert Hoover and the Great Depression. Oxford: Norton Publishing Co., 1976.

Werstein, Irving. A Nation Fights Back: The Depression and its Aftermath. New York: Julian Messner, 1969.

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