The great depression in America was caused by the combination of a gold shortage and price controls.
During the 1920s, the total amount of money in all bank accounts of all people in America increased. This increase was greater than the increase in other economic statistics.
Some economists studied the 1920s and saw prosperity. Prices were stable, unemployment was low, and the standard of living was rising. These economists thought the increase in bank accounts was good because the increase in bank accounts was a result of prosperity. These economists thought that the divergence of bank acounts from other economic statistics was a result of changes in peoples' relationships to banks and was not a problem.
Other economists studied the 1920s and saw high inflation and imminent economic disaster. These economists thought the increase in bank accounts was bad because the increase in bank accounts was inflationary. These economists said that the increase in bank accounts was too much larger than the increase in other economic statistics, and would result in very high inflation in the near future, and that the government needed to take drastic measures to stop inflation, and that America would suffer an economic disaster if the government did not take drastic action to stop inflation.
So in 1928 and 1929, the Federal Reserve System began trying to stop inflation.
Soon after the Fed began trying to stop inflation the great depression began.
The economists who thought the 1920s were prosperous said that the fact that the great depression began soon after the Fed began trying to stop inflation is proof that the Fed caused the great depression. Deflation occurred because the Fed tried too hard to stop inflation when there was no inflation, and the deflation caused the great depression. The Fed should not have tried to stop inflation. If the Fed had not tried to stop inflation, the prosperity of the 1920s would have continued. The Fed caused the great depression by creating too much deflation.
The economists who thought the 1920s were inflationary said that the fact that the great depression occurred is proof that the 1920s were inflationary. These economists had predicted an economic disaster, and their prediction came true. The great depression occurred because the Fed did not try hard enough to stop inflation and because the Fed waited too long before trying to stop inflation. The Fed caused the great depression by creating too much inflation.
There are two meanings of inflation. Sometimes inflation means prices are increasing. Other times inflation means the total of all bank accounts of all people is increasing. Usually these two phenomenom occur together, but the 1920s were unusual because bank accounts were increasing while prices were not increasing.
The economists who thought the 1920s were inflationary said the increase in bank accounts indicated an increase in the money supply, and an increase in the money supply would cause prices to rise. The absence of price increases was because there was a delay between the increase in the money supply and the increase in prices. Since the increase in prices had not occurred yet, the increase in prices would occur in the near future.
I think that if the money supply increases, prices increase very quickly. There might be a delay of a few days, but there will not be a delay of several years.
I think that bank accounts increased in the 1920s because more people were saving more of their incomes. Fewer people were spending all of their income as soon as they received the income. Consumer spending did not increase as much as consumer incomes. Consumer saving increased by more than consumer spending. Inflation did not occur because the increase in the money supply was counterbalanced by a decrease in the velocity of circulation.
So I think that the theory that the great depression was caused by deflation is more credible than the theory that the great depression was caused by inflation.
However, I am unconviced by both theories because I am unconvinced that the Fed was powerful enough and effective enough to have a significant impact on the economy. See the Federal Reserve System is a secret fascist conspiracy
There were multiple types of banks in America. There were state banks and national banks. There were commercial banks and savings banks. The Fed had different amounts of influence over different types of banks. If the Fed caused the great depression, then why didn't the banks which were most subject to the Fed fail first, and why didn't this create an opportunity for the banks which were less subject to the Fed to expand?
The Fed loans money to nongovernment banks. The Fed refuses to loan money to banks which do not comply with Fed rules. Some people say in the late 1920s the Fed stopped lending to banks. If that was true, then banks no longer had any incentive to comply with Fed rules. If the banks had no incentive to follow Fed rules, then how could the Fed have controlled the banks? Why didn't the banks ignore the Fed and act as if the Fed did not exist?
If the Fed stops lending to banks, then the results should be the same as if the Fed is abolished. It is illogical for libertarians to say that the Fed should be abolished because the Fed caused the great depression by doing nothing. Doing nothing is the same as not existing.
If the Fed caused the great depression, there should have been an incentive to evade the Fed. see government policies which are in opposition to the free market cannot be enforced without terror. Why didn't entrepreneurs respond to the incentive? If banks could not lend money, why didn't banks refuse deposits, and why didn't the people who could not borrow from banks borrow from the people who could not deposit money in banks? Why didn't entrepreneurs invent nonbank banks which acted like banks but were exempt from Fed rules? If the Fed shut down the banking system, why didn't a black market banking system appear?
The government spent much more enforcing prohibition than enforcing Fed rules, and prohibition was ineffective. If the Fed caused the great depression, then the Fed must have been more effective than prohibition, but I do not think that is probable.
Also, neither theory gives a satisfactory explanation of why the great depression lasted so long.
I think the Fed did create deflation in the late 1920s and early 1930s, and this did contribute to the great depression, but I do not think this was the only cause of the great depression.
In America in the 1920s, new technology resulted in increased production of wheat, cotton, coal, steel, etc. However, gold production declined because mines were used up, and few new mines were discovered. While gold production was declining, demand for gold was rising because of the economic boom, which was caused by new technology. By the late 1920s America had a gold shortage.
During and after World War I, european nations send gold to America to pay for wartime supplies and postwar reconstruction supplies. This prevented the gold shortage from appearing in the early 1920s.
The government exacerbated the gold shortage by increasing gold reserves. The government was hoarding gold.
Usually a shortage causes prices to rise, but the price of gold could not rise because the american dollar was linked to gold. Since the price of gold could not rise, the price of everything else had to fall. see The gold standard is a bad policy. But farmers complained when the prices of wheat, cotton, etc declined. When the price of steel and coal fell, steel and coal companies reduced wages, and workers complained. So the government tried to prevent prices from falling. The government tried to mandate high prices, but buyers did not have enough money to pay the high prices. Farmers and businesses were unable to sell their products and went bankrupt and the workers lost their jobs.
The american price supports in the late 1920s and 1930s deserve closer study. Price controls are difficult to enforce, and usually result in surpluses or shortages, and black markets. The government did not devote many resources to enforcing price controls, and so it appears that the price controls should not have been effective enough to contribute to the great depression.
But the government did succeed in enforcing price controls. The government threatened a few large businesses. These businesses submitted. Then the government required these businesses to threaten their suppliers and customers. The government succeeded in enforcing price controls with little effort by conscripting businesses into enforcing the price controls for the government.
Another reason why the price controls were effective was that the government targetted industries which were unsuitable for black markets. During prohibition, people made beer in their bathtubs and kept stills in their backyards. But making steel in your backyard is more difficult. (But not impossible, some people make steel in their backyards as a hobby, Lindsay Publications will sell you books telling you how.) Making steel has more economies of scale than making alcohol, so small scale steel production is more inefficient than small scale alcohol production. But black markets work best with small scale production. And steel is worth less per pound than alcohol. Black markets work best with small but valueable objects. Black markets are impractical when the cost of hiding objects exceeds the black market price of the objects. And most steel was sold to railroads, which were too heavily regulated to buy steel from the black market.
The government was following two incompatible policies. The gold standard was incompatible with price supports.
If the government had abandoned the gold standard, the government could have ended the great depression with inflation. Inflation is usually equivalent of a subsidy to people and businesses who are in debt, because higher wages and prices make it easier to repay debt. Inflation is usually the equivalent of a tax to people who have savings, because high prices mean that you can buy less stuff with your savings. However, if the government had created the exactly correct amount of inflation, only the price of gold would have risen, and most other prices and wages would have have changed little, so there would not have been a big effect on savers and borrowers.
If the government had abandoned the price supports and allowed deflation, farms and businesses could have sold their products. Businesses would not have gone bankrupt, and workers would not have lost their jobs. Workers would have seen reduced wages, but workers would have survived the reduced wages because the prices of the things which workers buy would have fallen faster than wages. Deflation is usually the equivalent of a subsidy to anyone who has savings, because lower prices mean that you can buy more stuff with your savings. Deflation is usually the equivalent of a tax to people and businesses who are in debt, because lower prices and wages make it more difficult to repay debts. Extreme deflation makes it impossible to repay debts, and results in bankruptcy to people and businesses who are in debt.
Both of these solutions to the great depression were known at the time and were endorsed by prominent economists. There were multiple conferences of economists which debated solutions to the great depression. Some economists favored inflation. Some economists favored deflation. Since the economists did not agree, the government did not attempt either solution. Instead the government tried to compromise by combining a little inflation with a little deflation, which accomplished nothing.
Sudden changes in deflation/inflation are very disruptive to the economy. If deflation/inflation remains constant, people can adapt, and the economy can function even with high levels of deflation or inflation. If the government abandoned the gold standard or price supports in the 1920s, the great depression would have been prevented by a small amount of constant inflation or deflation for many years. But by 1930, it was no longer possible to end the great depression without a large increase in deflation or inflation. The government had to decide whether to endure the economic disruption caused by an abrubt, massive burst of inflation or deflation in order to end the great depression quickly, or to prolong the great depression by avoiding further disruptions to the economy. By 1930, the government could not end the great depression quickly without first making the great depression worse.
People can adjust to constant inflation or deflation, but it is easier to adjust to high inflation than to high deflation. This is because the most important adjustment is interest rates. If real interest rates are five percent and inflation is fifty percent, then the economy can function if the nominal interest rate is fifty five percent. But if real interest rates are five percent and deflation is fifty percent, then nominal interest rates need to be minus forty five percent. Negative nominal interest rates are impossible because if the bank pays negative interest, you will with withdraw your savings and stuff the cash in your mattress. When nominal interest rates are negative, lenders achieve greater profits by holding money than by lending money. If in the 1930s the government had decided to end the great depression as quickly as possible even if that meant making the depression temporarily worse, the government would have had to use inflation, not deflation, because a high inflation rate is less disruptive than a high deflation rate.
The great depression shows why the gold standard is a bad idea. If there is a gold standard, then any change in the supply or demand for gold requires that the prices of everything other than gold must change. The gold standard results in high price volatility. It is better to link money to an index of commodity prices than to an individual commodity like gold, because the index will be much less volatile than any of its commodity components.
People seem to be more psychologically tolerant of fluctuating prices than of fluctuating wages, and of rising than of falling prices. So maybe the monetary authorities should try to stabilize wages instead of stabilizing prices, and should err towards inflation rather than towards deflation. However, every person has different skills and the skills of every person change over time as people learn new skills or become less capable with age. Also the demand for each skill is not constant. So it would be very difficult to determine whether changing wages are due to changes in the supply and demand of skills, or due to macroeconomic effects like inflation. If you get a pay increase, is that because of inflation, because you are getting better at your job, or because all the other people who could do your job died and there is no one who could replace you if you quit? I think it is better to measure inflation in terms of commodity prices because commodity prices can be measured more accurately than wages, retail prices, or real estate prices.
The great depression finally ended for several reasons.
The government made it illegal for ordinary people to own gold, which reduced the demand for gold and made the gold shortage less severe. This also made the gold standard meaningless. This was a way for America to go off the gold standard while pretending to remain on the gold standard. According to the old real gold standard, anyone could bring paper money to the government, and the government would trade the paper money for gold. According to the new phony gold standard, anyone could bring paper money to the government, and the government would trade the paper money for gold, and then the government would throw the person in jail for possessing gold.
Actually the gold standard was already phony, but the new rules made the phony gold standard even more phony.
The government's price supports were ineffective, and deflation occurred despite the government's opposition to deflation.
Before the great depression, most banks kept gold as a reserve. After the great depression, most banks kept government bonds instead of gold as a reserve. This was a change in government banking regulations. This resulted in a reduced demand for gold, which made the gold shortage less severe. The government made these changes in banking regulations to help fund world war II.
When world war II began, people became more patriotic. People gave up things and bought government bonds. This reduced the demand for gold.
When world war II began, the government became focused on the war, and had less time to interfere in the economy. When government interference in the economy declined, the economy improved.
Government spending on world war II did NOT contribute to the end of the great depression.
This is more of a hypothesis than a proof. I do not have time to look up statistics about how much gold was mined each year, or how much gold was stored in banks, or how many banks the Fed prosecuted for failing to obey the Fed. I read somewhere that gold mining declined in the 1920s, but I do not remember where.
In The Notion that Caused the Great Depression by Richard H. Timberlake, Liberty magazine, June 2006, pages 35-41; Timberlake says the great depression was caused by real bills.
A real bill is a loan from a bank to a business for the purpose of producing goods. Some economists thought that real bills were good, and that every other kind of loan was speculative and was bad.
Timberlake says that in October, 1928, Benjamin Strong, governor of the Federal Reserve Bank of New York, died. Strong had controlled the Federal Reserve System. After the death of Strong, the Fed was controlled by Adolph C. Miller, a member of the Federal Reserve Board. The change in leadership resulted in an abrupt change in Fed policy. Miller thought there was too much speculation and required that all bank loans be real bills only. The Fed created deflation because the Fed was obsessed with real bills.
However, if the Fed had really wanted to promote real bills, then I think that the Fed would have singled out some banks for special punishments for making too many speculative loans, and the Fed would have singled out other banks for special rewards for making real bills. And if the Fed started favoring some banks over others, I predict the policy would quickly degenerate into corrupt crony capitalism, with the Fed subsidizing crooked friends. Entrepreneurial criminals would have disguised speculative loans as real bills and collected subsidies from the Fed, and crooked banks would have gained market share from honest banks. But Timberlake's data suggests that the Fed did not single out any banks for special treatment. Instead the Fed restricted loans to all banks. This suggests that the Fed was more interested in fighting inflation than promoting real bills.
If the Fed had been serious about promoting real bills, the Fed would have lavished credit on those banks which complied with the Fed's real bills doctrine, and the result would have been inflation, not a depression.
In America's Great Depression; by Murray Rothbard; published by Richardson and Snyder; 1963, 1972, 1975, and 1983; Rothbard says the great depression was caused by inflation and price supports.
Rothbard says there was inflation in the 1920s because the money supply increased, according to various banking statistics. But I think that there was no inflation in the 1920s because prices were reasonably stable.
Adolph Miller, who was Timberlake's main villain, is one of Rothbard's heros.
Rothbard says that fractional reserve banking causes inflation, and therefore fractional reserve banking should be illegal. Banks should be required to keep full reserves. I think that is absurd. All banking is fractional reserve banking. If fractional reserves are outlawed, then banking is effectively outlawed. The reason banks accept deposits is because banks can make a profit by lending deposits to other people. If banks are forbidden to lend deposits to other people, then there is no way for banks to make a profit from deposits, and banks would refuse to accept deposits. And if a bank does not accept deposits and lend the money to other people, then there is no reason for the bank to exist.
But I agree with Rothbard that price supports were partly to blame for the great depression. I got the idea that price supports were partly to blame for the great depression from Rothbard.
In Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy; by Richard H. Timerlake Jr;The Independent Review; volume XI, Number 3, Winter 2007; pages 325-354; especially pages 342-343; Timberlake says that the USA Federal Reserve Bank was hoarding gold 1929-1933. This would have exacerbated or caused a gold shortage, which would have exacerbated or created a recession or depression. However, Timberlake's data about gold reserves does not show a big change in gold reserves.
The small amount of data which I have seen shows stable prices and an increasing money supply before 1929, and then declining prices and a declining money supply after 1929. Thus it appears that the Fed's policy before 1929 was stable prices, regardless of the effect on the money supply. And it appears that after 1929 the Fed's policy was a stable money supply, regardless of the effect on prices, and that the Fed was trying to shrink the money supply to undo the money supply growth of the 1920s. The change in Fed policy occurred at the same time as the death of Strong and the beginning of the great depression. This is probably not a coincidence.
But I do not think that Miller caused the great depression by changing Fed policy for two reasons.
I do not think that the Fed was powerful enough or had enough control over private banks to have a big impact on the economy. I think the Fed could have created a small depression but not a big depression. But I might be wrong. The problem is that when people study the actions of the Fed, they neglect to study how private banks responded to the actions of the Fed. In the absence of evidence that private banks did or did not obey the Fed, I assume that private banks disobeyed the Fed at every opportunity, because it is human nature to resent being controlled by other people. Also most private businesses are more interested in earning a profit than in catering to the whims of bureaucrats.
Some banks would have obeyed the Fed. Some banks would have defied the Fed. Some banks would have ignored the Fed. Some banks would have pretended to obey the Fed. If the Fed's efforts to enforce Fed policy were characterized by the incompetence which is typical of government, then the banks which lied and pretended to obey the Fed would have been more successful than the other banks. The most likely outcome of bad Fed policy is that banks would become more crooked and dishonest, not a depression.
The Fed could not have enforced Fed policy on private banks without either an unusually high level of competence or an unusually high level of brutality. I do not see evidence of either.
Free markets normally adjust to changed circumstances; the free market should have responded to the Fed's policy of shrinking the money supply by reducing prices, and the depression should have ended when prices fell to the appropriate level. Since the great depression continued for a long time, there must have something like government price controls which prevented the free market from returning to equilibrium.
I have heard many theories about the cause of the great depression. Most theories are unconvincing. I do not remember where I heard the theory that the great depression was caused by a gold shortage, and I do not have any statistics about actual gold production, but I think the gold shortage theory makes more sense than any other theory. Even if I had statistics about gold production, I am not sure if I would trust the statistics, because gold miners often understate the amount of gold which was mined so they can pay less to their investors and to the tax collectors.
The only other theory about the great depression which seems credible is Richard Timberlake's theory: During the 1920s, the Federal Reserve System was controlled by Benjamin Strong, who attempted to keep prices stable. Strong died in 1928, and the Federal Reserve System was taken over by Adolph Miller. Miller declared war on speculation. Since most banks were making loans to speculators, Miller destroyed the banking system in order to prevent the speculators from getting loans.
Thus I think the great depression was caused by a gold shortage, and exacerbated by the Fed's policy of hoarding gold and shrinking the money supply; and the economy failed to return to equilibrium for many years because of government overregulation.
In the book The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression by Scott B. Sumner, Independent Institute, 2015; says a gold shortage was one of the causes of the great depression.