5 Causes of the Great Depression

In the 1920s, nations bounced back from the disruption and destruction caused by World War I, with factories and farms producing again, Richardson notes. But the nature of the economy in the United States and elsewhere shifted, as ordinary consumers buying durable goods such as appliances and cars—often on credit—became more and more important.

While that consumption created a lot of wealth for business owners, it also made them vulnerable to sudden shifts in consumer confidence. At the same time, nations that were producing a lot of products and exporting them became fierce competitors. “The war had eliminated a lot of the cooperation between nations that were required to run the international financial system,” Richardson says. That inability to work together at controlling problems meant that any one country’s efforts to control a downturn were less effective.

The 1920s economic boom helped breed a widespread belief that it was easy to get rich quickly if you were bold enough to invest in the right opportunity at the right time. That’s one reason why so many ordinary Americans were fleeced by con artists who sold them on shady schemes, from Florida swampland and nonexistent oil deposits to the notion of buying Spanish mail coupons and redeeming them for U.S. stamps to profit on the weaker Spanish currency.

But the riskiest gambling took place on Wall Street. Investors increasingly bought stocks on margin, in which they put down as little as 10 percent of the price of a stock, and borrowed the rest of the money, with their stock itself as collateral. Corporate stocks soared, and brokers made huge commissions.

The Federal Reserve System, created in 1913, was supposed to ensure the nation’s economic stability by controlling the money supply. But the still-new institution’s policies in the 1920s not only failed to stop the Great Depression but may have actually helped to cause it.

“There was a drastic 67 percent increase in the money supply between 1921 and 1929,” explains Daniel J. Smith, a professor of economics and finance and director of the Political Economy Research Institute at Middle Tennessee State University.

That policy led to declining interest rates, which encouraged people to borrow and overinvest. “It also led to unchecked speculation in the formation of a bubble in the stock market,” Smith says. “Normally, overinvestment would lead to rising interest rates, which would act as a natural brake to prevent a bubble from forming. This didn’t occur due to the easy monetary policies of the young Fed.”

But eventually, in 1929, the Fed’s board worried that speculation was out of control, and abruptly slammed on the brakes by contracting the money supply and raising interest rates, Smith notes.

The Fed’s move to cool the stock market worked a little too well. “They got the stock market to come down,” Richardson explains. “But then it came down a lot, and it came down very quickly.”

Back in 1929, the United States—like many other countries at the time—was on the gold standard, with the dollar redeemable in gold and pegged to its value. But after the Wall Street crash, nervous investors began to trade their dollars for gold.

As former Fed chairman Ben Bernacke noted in a 2004 lecture, the Fed then moved to jack up interest rates higher to protect the dollar’s value. But those high-interest rates made it difficult for businesses to borrow the money that they needed to survive, and many ended up shuttering their doors instead.

Trade protectionists in Congress enacted the Smoot-Hawley Act, which was written in early 1929, while the economy still seemed to be going strong. But after the Wall Street Crash weakened the economy, President Hoover still signed it into law in 1930.

The Smoot-Hawley Act raised U.S. tariffs by an average of 16 percent, in an effort to shield American factories from the competition with foreign countries’ lower-priced goods. But the move backfired when other countries put tariffs on U.S. exports.

“If you're a country and you impose tariffs that can be good for your domestic industries because your domestic energy might produce more for home consumption,” Richardson says. “But if other countries retaliate, then it could be bad for everybody.”

The really unlucky thing was that all those factors combined at about the same time in a perfect economic storm, whose devastating effects had long-lasting repercussions. As Richardson notes, the U.S. economy didn’t again reach full employment until 1940—just in time for World War II to disrupt consumption with rationing needed to ensure that the military had enough resources. Life didn’t really get back to normal until after the war when the victorious United States emerged as the world’s leading economy.