What Caused the Great Depression and Can We See Similarities Today?

All You Need To Know About Great Depression and Can We See Similarities Today?

What Caused the Great Depression and can we see similarities today? The last 100 years have had many recessions and economic crises. The current global economic crisis may very well be the worst of all. Even the IMF has now said that the current crisis may be worse than the Great Depression. There have been roughly 6-7 financial crises in the last century, with the Great Depression being the most disastrous one so far, the current crisis cannot be counted yet. The reason is that it is still developing and no one can say for sure how much damage it will inflict upon the global economy.

One way to understand how financial crises develop is to study the history and look at the previous financial crises to see how they developed and how they were controlled. This study of history can give us an insight that may help us control the present disaster that is unfolding. Although so far it seems that all attempts to contain the extent of financial contagion have failed because the root cause of this crisis is the virus and till the virus is contained. It will be very difficult to control the economic condition.

1. The Old World

If we look at the past then we can see that the old world was not as interconnected and dependent on international trade as we are now. International trade developed after Adam Smith and David Ricardo laid down the foundations of the classical school of economic thought. Till then, the world had a feudal mercantile system, where economies were not interconnected and thus not very dependent on each.

It was the rise of Classical economic theory, Ricardian and then Keynesian thought that led to free trade agreements, international trade and government intervention to guide and control the economy. Therefore closed economies from the old world became less susceptible to the economic and financial crisis because they were not dependent on others and they were ruled in a top-down manner by the monarch or the ruler. Therefore a strict administrative setup ensured delivery of crops and necessities. Crises therefore in the old world occurred in the form of natural calamities like drought or famine or when an enemy attacked.

The modern world, which was shaped after the rise of classical and Keynesian economics, is a very different world where economies are not only interdependent but the economic structures are such that it becomes very difficult for a government to control a crisis once it starts to unfold.

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2. What Caused the Great Depression?

There is never any single factor that results in an economic crash. An economic crash is usually a combination of different risk factors coming together at the right time or the worst time? To trigger a collapse.

The Great Depression began in 1929 and this was the post WWI world. Almost over a decade had passed since the first world war that had inflicted heavy damage on the world economy. But the world had come out of the economic crisis created by the war fairly quickly. The American economy, in particular, was on the rise, the American dream had gripped everyone like a fever.

The American economy expanded, factories set up, unemployment reduced and people spent money to consume more and more goods. This spending pattern increased aggregate demand. To increase production, the American producers took out loans from commercial banks to fund their expansion projects.

Stock Market

We continue to ask what caused the great depression and can we see similarities today? Investing was becoming popular among the people and the stock market was the most attractive place to invest funds to generate quick profits through speculation.

People even mortgaged their homes to invest in the stock market. Because the prospect of making a profit in the bullish market was far too alluring. This meant that the stock investments became financed by debt. Also, the investors were hoping to make a profit to pay off that debt. Also, earn a margin over it. In simple words, the stock investment was highly leveraged.

Gold Depletion

In addition to this, at that time America had a trade surplus with other countries. America exported more than it was importing to the world and this meant that other countries had trade deficits with America. They had to pay for the deficit using the gold and silver reserves that they had. This is because we are still talking about the time when the gold standard was the base of the economy.

Income Inequality

Income inequality is another factor that was silently present in the backdrop of the great depression. In 1929 the richest 1% of people in America earned almost 20% of the national income. Although that income divide has increased today in 1929 this divide was too great by the standards of that day and age.  

The thing about income inequality is that it skews the growth of any society, on the surface, it may appear as if the economy is growing equitably but the grassroots situation shows that the poorest social classes suffer the most because growth comes with a rise in price level while wages remain sticky.

Trade War

Tariffs and a trade war became the cherry on top of the Great Depression. Sounds familiar right?  The Smoot Howley act became introduced in 1929 and passed by Congress in 1930.  It protected American farmers from overseas competition. The policy to protect local farmers however backfired because as soon as America imposed tariffs on the imports from other countries, the affected countries too imposed reactionary tariffs. This is on American exports.

All of these factors culminated in the great depression. All of these factors culminated in the great depression. The banks became overheated, the credit bubble was becoming unsustainable. Furthermore, other countries paid the USA in gold. They soon realised that they run out of gold if they kept importing US goods. This was followed by the trade war and the foreign banks raised their interest rates. This is to prevent their reserves from depleting. It caused a drop in productivity in other countries that also resulted in reduced trade. This caused a drop in productivity n other countries that also resulted in reduced trade.

In the USA, the banks began to weaken and this weakness translated into a drop in the stock market profitability. As the profit of the investors reduced, they suddenly realised their inability to pay back their debts. This created a vicious cycle that result in banks not being able to realise their debts. The stock market finally crashed in October 1928, marking the beginning of the Great Depression.

Many economists consider that the Federal Reserve also played a key role; Milton Friedman especially criticised the Federal Reserve for not being aggressive enough. Also, taking the wrong policy decisions by not helping banks. According to Friedman, Federal Reserve could have limited the Great Depression to a series of small recessions. It would have been easier to control.

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3. Similarities We See Today

What caused the great depression and can we see similarities today? If you have been reading this attentively you must have seen the similarities that the current economic crash has with the Great Depression. The US-China trade war has been threatening world trade since President Trump came to power. It caused entire supply chains to shift from China into other Asian countries.

But this is just one trade war that came into the limelight. 2019 also saw a smaller trade war between South Korea and Japan. This happened when the two countries locked horns over compensation payments of crimes committed in WW2. This resulted in Japan limiting the export of key raw materials that go into making semiconductors. These materials are the main production of South Korea.

Similarly, income equality today is far too greater than what it was in 1928. The divide between the rich and the poor has increased many folds. Finally, it was the stock market crash in 1928 that triggered the depression. Similarly, it was the stock market crash in February and March that resulted in worsening the current crisis.

Conclusion

What caused the great depression and can we see similarities today? These similarities may make one think that we are on the same trajectory as 1929 but we are not. In 1929 no Coronavirus existed. Today the world is under the deadly grip of this virus and until its cure is found any hope of saving the crippling world economy is too faint.

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