Classical Economic Theory and the Great Depression in the United States

Abstract

The Great Depression is one of the most tragic economic depressions in United States history. In October 1929, the United States stock market crashed, causing widespread unemployment, business failures, bank collapses, and a decline in industrial production. From 1929 to 1933, approximately one-quarter of the workforce in the United States was unemployed. There have been long-standing debates among historians and economists about the causes of the Great Depression. One theory that has been contentious and proven to be unworthy of the success of the recovery from the Great Depression is that of the classical economic theory.

Introduction – Classical Economic Theory and the Great Depression

The United States has one major economic crisis that is still discussed in history classrooms across the nation: the Great Depression. In 1929, when the stock market crashed, there was widespread unemployment, business failures, bank collapses, and declining industrial production within the United States. Nearly one-quarter of the United States by 1933 faced workforce unemployment. Economists and historians have debated over the years what factors contributed to this economic failure of the late 1920s. Free markets gradually moved toward an equilibrium through adjustments in price, wages, and interest rates, which were the classical economists’ beliefs. To apply this theory to the Great Depression, insight is needed into how economists understood economic downturns and why policymakers initially resisted intervention from the government.

Methodology and Sources

While researching this topic, it was imperative to employ qualitative historical methodology while incorporating primary and secondary sources. Examples of the primary sources utilized include writings of classical economists such as Adam Smith, David Ricardo, and later economists, all of whom influenced policymakers with their ideas in the early twentieth century. Additional primary sources are government reports, speeches, and economic data from the Hoover administration. These provide evidence about how policy decisions were based on classical assumptions.

Next, it is a necessity to ensure that secondary scholarly sources are utilized to enhance the primary sources while studying the classical economic theory within the context of the Great Depression. These studies were conducted, analyses of classical economic thought, and evaluations of responses to policy during the 1930s. Historical context is needed in order to provide a helpful understanding of this source’s place in classical economic theory, but all assess the effectiveness in reiterating the economic events. When combining primary and secondary sources, it provides further evidentiary understanding within historical scholarship of how classical theory was utilized during the times of the Great Depression.

Classical Economic Theory and Its Ties to the Great Depression

The main theory behind classical economics is that the market can self-correct. This theory also assumes that economic downturns only occur when there is a temporary disruption that interferes with normal markets. Balance should be restored when investments are encouraged, employment increases, and the activity of the economy is stimulated, ultimately restoring the falling prices and wages.

Several factors played a role in the onset of the Great Depression from the perspective of the classical economist.

We could not but be affected by the degenerative forces moving elsewhere in the world. Our immediate weak spot was the orgy of stock speculation which began to slump in October 1929. The inflation which led to the orgy was a contributory cause of our own difficulties. Secondary causes arose from eight years of increasing productivity.^[1]

 In October 1929, when the stock market crashed, a decline in the confidence of investors and a reduction in wealth. Responses from businesses were to decrease production and hold off on investments. One of the hardest hit businesses, that of the bank, became extremely cautious by limiting credit and reducing economic activity. Firms lowered output and employment when the demand began to decline.

Equilibrium of wages and prices that had significantly declined were expected to naturally be restored by the classical economists. The belief with these economists was that as wages were lowered, it would mean that production costs would be less, thus encouraging businesses to want to hire individuals. Consumer demand would increase because of the products being at a reasonable cost because of the falling prices. Investment then would be stimulated and encouraged because of the lower interest rates, also promoting recovery at a natural rate.

Unbeknownst to these classical economists, the Great Depression would span a longer period than expected. Instead of the market, jobs, and wages naturally recovering, they rapidly declined, causing a major decline in economic growth. Wages and consumer spending massively decreased, which contributed to a deeper economic contraction. With the unemployment rates persistently increasing, the classical assumption of natural equilibrium in the markets was beginning to be challenged.

President Herbert Hoover was in favor of the classical economic theory and principles in the beginning. Hoover believed that if businesses, local governments, and charitable organizations worked together voluntarily, the economic difficulties could be handled and recovered without the need for federal intervention. There was a fear of what would become of the economic recovery if the federal government intervened, in the eyes of Hoover, as he felt that there would be discouragement of private-sector recovery and undermine fiscal stability. Each of these policies displays where classical theory placed its emphasis on limiting government involvement in these economic affairs.

The End of the Great Depression and the Classical Economic Theory

In the beginning, classical economists believed that the market would naturally restore itself to its original standing. However, this would prove to be an inefficient way of handling this massive historical economic disparity within American history. Lowered prices and reduced costs over time eventually restored confidence, thus producing a stimulation in production and employment.

There are debates amongst scholars regarding the effectiveness of classical economics; some state it would not be able to end the Great Depression on its own, while others state that some of these elements were what contributed to the gradual recovery during the 1930s.

A number of free market-oriented economists and historians have disagreed. They acquitted the policies of the Coolidge years of the charge of involuntary manslaughter in the 1929 case of homicide in which the economy died. The cause of death, these neoclassical crime scene investigators maintained, was government intervention rather than the lack thereof.^[2]

 One federal policy that went into play during the Great Depression is what ultimately introduced the necessity for the federal government to intervene in public works projects, banking reforms, and regulatory measures. This policy was known as the New Deal. This policy was far from the philosophies of classical economists because of the intervention of the federal government.

On the other hand, the foundations of the American financial structure and the character of the monetary standard were profoundly modified. Both developments were direct outgrowths of the dramatic experiences of the preceding years. The apparent failure of monetary policy stem the depression led to the relegation of money to a minor role in affecting the course of economic events. At the same time, the collapse of the banking system produced a demand for remedial legislation that led to the enactment of federal deposit insurance, to changes in the powers of the Federal Reserve System, and to closer regulation of banks and other financial institutions.^[3]

The most important component that brought the United States into ultimate recovery was the economic mobilization of World War II. Industrial production and employment were significantly increased through massive government expenditures. Through the eyes of the classical economist, wartime production is what restored confidence, expanded markets, and idle resources were now being utilized. However, those who opposed classical economics state that the intervention of the federal government on such a large-scale contradicts the classical economists’ prescriptions.

The Great Depression unearthed the weaknesses within the United States classical economic theory, especially that of its reliance on rapid market adjustment. The classical economists emphasized the importance of market incentives and long-term equilibrium correctly, but they underestimated the economic downturns that could last through extended periods. Traditional assumptions began to be reconsidered because of the inability of wages and price adjustments not being able to be restored to full employment.

Conclusion

The framework provided by the classical economic theory is important to understanding the Great Depression. It provides an understanding of market equilibrium, wage flexibility, and limited government intervention, which shaped earlier policies and responses to this economic crisis. Many believed that the markets would eventually level themselves out and ultimately correct themselves; however, the depth and duration of these economic depravities during the Great Depression revealed the limitations within this framework. Most historians do perceive that market adjustments helped the recovery, but they feel that most of the full recovery and an end to the crisis came from government intervention and wartime mobilization. The Great Depression has proven that it was a critical turning point regarding economic thought because of it challenging classical orthodoxy but also influencing debates about the role of the government in economic affairs.

Bibliography

Primary Sources

Hoover, Herbert. The Memoirs of Herbert Hoover: The Great Depression, 1929-

1941. Place of publication not identified: Orth Press, 1953.

https://search.ebscohost.com/login.aspx?

direct=true&scope=site&db=nlebk&db=nlabk&

authtype=shib&custid=liberty&AN=2004150.

Secondary Sources

Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press, 1963.

McElvaine, Robert. The Great Depression: America, 1929-1941. New York, NY: Three Rivers Press, 2009.

^[1] Herbert Hoover, The Memoirs of Herbert Hoover: The Great Depression, 1929-1941 (Place of publication not identified: Orth Press, 1953), 13, https://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&authtype=shib&custid=liberty&AN=2004150.

^[2] Robert McElvaine, The Great Depression: America, 1929-1941 (New York, NY: Three Rivers Press, 2009), xviii.

^[3] Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960 (Princeton, NJ: Princeton University Press, 1963), 469.