A review of Keynesian theory

To understand the Great Depression, it is important to know the theories of John Maynard Keynes (rhymes with "rains"). Keynes is known as the "father of modern economics" because he was the first to accurately describe some of the causes and cures for recessions and depressions.

In a normal economy, Keynes said, there is a circular flow of money. My spending becomes part of your earnings, and your spending becomes part of my earnings. For various reasons, however, this circular flow can falter. People start hoarding money when times become tough; but times become tougher when everyone starts hoarding money. This breakdown results in a recession.

To get the circular flow of money started again, Keynes suggested that the central bank -- in the U.S., the Federal Reserve System -- should expand the money supply. This would put more money in people's hands, inspire consumer confidence, and compel them to start spending again.

A depression, Keynes believed, is an especially severe recession in which people hoard money no matter how much the central bank tries to expand the money supply. In that case, he suggested that government should do what the people were not: start spending. He called this "priming the pump" of the economy. Indeed, most economists believe that only massive U.S. defense spending in preparation for World War II cured the Great Depression.

After its success during the war, almost all free governments around the world became Keynesian. Its policies have dramatically reduced the severity of recessions since then, and appear to have completely eliminated the depression from the world's economies. (More)

Events of the 1920s
The Roaring Twenties were an era dominated by Republican presidents: Warren Harding (1920-1923), Calvin Coolidge (1923-1929) and Herbert Hoover (1929-1933). Under their conservative economic philosophy of laissez-faire ("leave it alone"), markets were allowed to operate without government interference. Taxes and regulation were slashed dramatically, monopolies were allowed to form, and inequality of wealth and income reached record levels. The country was on the conservative's preferred gold standard, and the Federal Reserve was not allowed to significantly change the money supply.

The fact that the Great Depression began in 1929, then, on the Republicans' watch, is a great embarrassment to conservative economists. Many try to blame the worsening of the Depression on Hoover, for supposedly betraying the laissez-faire ideology. As the time line in the next section will show, however, almost all of Hoover's government action occurred during his last year in office, long after the worst of the Depression had hit. In fact, he was voted out of office for doing "too little too late." The only notable exception to his earlier idleness was the Smoot-Hawley tariff of 1930, whose minor impact we shall explore in more detail later on.

But much more importantly, the economy was clearly turning downward even before Hoover took office in 1929. Entire sectors of the economy were depressed throughout the decade, like agriculture, energy and mining. Even the two industries with the most spectacular growth -- construction and automobile manufacturing -- were contracting in the year before the stock market crash of 1929. About 600 banks a year were failing. Half the American people lived at or below the minimum subsistence level. By the time the stock market crashed, there was a major glut of goods on the market, with inventories three times their normal size.

The fact that all this occurred even before the first act of government intervention is a major refutation of laissez-faire ideology. (More)

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