Explaining Exactly Why the Great Depression Happened

The Great Depression happened for one simple reason - the Federal Reserve did the exact opposite of what it was created to do. In the simplest of terms, the Great Depression happened because the Federal Reserve sold assets in the marketplace instead of buying assets beginning in 1930 after the stock market crash of 1929.

As the Federal Reserve sold assets into the marketplace the government created institution drained money out of the economy. When the Federal Reserve sells assets, those assets (mainly government bonds) are paid for with cash which goes back into the Federal Reserve and is no longer available for public consumption.

As the Federal Reserve kept selling assets and draining cash out of the economy in the early 1930s, all the money still left in the economy kept gaining in value. As money kept gaining in value people stopped spending their money (they hoarded it instead) and economic activity collapsed causing the Great Depression. (See 1 below)

• The Federal Reserve Act

The Federal Reserve was created in 1913 by Congress and President Woodrow Wilson with the passage of the Federal Reserve Act. In the first sentence of the Federal Reserve Act (official title) it says, "An Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, ..... .

The word elastic is defined as: (of an object or material) able to resume its normal shape after contraction ... . The main reason the Federal Reserve was created, as specifically stated right at the beginning of the Act, is for the Federal Reserve to make the economy resume its normal shape after contraction.

What is being contracted is the amount of money (currency) in the economy.  In theory, when the amount of money in the economy declines the Federal Reserve is there to replace the lost money and prevent any contraction. If the lost money is replaced quickly enough then money itself will not appreciate or gain in value. If money does not appreciate or gain in value then people will continue to spend money at normal levels and economic activity continues.

If money did not gain in value in the early 1930s, the Great Depression would not have happened. But it did happen because the Federal Reserve did the exact opposite of what it was charged to do in the Federal Reserve Act. Instead of furnishing an elastic currency and replacing all the money lost in the economy (due to the 1929 stock market crash and ensuing credit crisis) by purchasing assets in the marketplace (when the Federal Reserve buys assets it pays for the assets with cash which then becomes available for public consumption) the Federal Reserve did the exact opposite and sold assets thereby draining the economy of even more cash.

It's very simple. The Federal Reserve caused the Great Depression by doing the exact opposite of what it was created to do. Instead of providing cash to the economy in the early 1930s (creating an elastic currency), the Federal Reserve drained cash out of the economy causing money to soar in value which caused all Americans to cease spending which caused economic activity to collapse. (2)

Using a real world example: In 1929, one of my grandfathers ran a successful business with 20 employees and he had around $100,000 in the bank. After the stock market crashed and credit got very tight, in 1930 my grandfather's business went bust and he went to his bank to get his money and was paid only eight cents on the dollar or $8,000 instead of $100,000.

The same thing or worse happened to tens of millions of other Americans. Some people lost every penny of the money they had in banks. As this process played itself out, the amount of money in the economy contracted creating an inelastic currency. All the money still remaining in the economy appreciated tremendously in value and people stopped spending their remaining money.

As dictated by the first line in the Federal Reserve Act, the Federal Reserve should have stepped in and replaced all the lost money to maintain an elastic currency. The Federal Reserve should have made good my grandfathers entire $100,000 and all the other money people had in the banks thereby preventing contraction or allowing the economy to rapidly resume its normal shape after contraction. 

The Federal Reserve could have done this directly by giving the banks all the money they needed to pay depositors or it could have purchased assets in the marketplace until it had replaced all the lost money in the economy. Had the Federal Reserve replaced all the lost money it would have prevented money from appreciating in value and people would not have hoarded their money and they would have kept spending their money and the Great Depression would not have happened.

Instead, the Federal Reserve sold assets in the marketplace thereby draining even more cash out of the economy making a bad situation even worse. (3) By 1933, the amount of money in circulation in the United States had declined by 25% from what is was in 1929. That caused all remaining money in the economy to become extremely valuable and people refused to spend their money. Why spend your money today when tomorrow it will be worth even more than today? (If a nickel today buys you one apple but tomorrow that same nickel will buy you two apples why spend it today?)

Of Special Note: In the early 1930s, Congress debated a bill which would have forced the Federal Reserve to purchase assets until wholesale prices rose back to their pre-1929 levels. Had this legislation been passed it would have ended the Great Depression (as long as the Federal Reserve followed the legislation). Unfortunately the members who supported this meaningful legislation were swept from office in 1932 and replaced by far less sophisticated people and the Great Depression lasted until 1939-40.

If at any time prior to 1939-40 had the Federal Reserve done what the Federal Reserve Act states, create an elastic currency, it would have ended the Great Depression. The enormity of that statement cannot be underestimated given what the Great Depression did to the world.

• Explaining the Great Recession and How It Ended

In the mid-2000s, the Federal Reserve sold assets in the marketplace to the tune of $750 billion dollars. That caused money to appreciate enough in value that most Americans greatly slowed their spending and the Great Recession occurred. 

This author sent a letter to then Secretary of the Treasury Hank Paulson trying to explain that it was the Federal Reserve's selling of $750 billion in assets that led to the crisis. Paulson got authority to borrow some $750 billion to stabilize the economy but this author tried to explain that borrowing $750 billion in the marketplace is not the same as the Federal Reserve replacing the $750 billion.

When Paulson went to the marketplace to borrow $750 billion, he was not replacing any lost money. He was simply borrowing money that already existed in the economy. That did not solve the problem. The Federal Reserve had to replace the lost money with money not already in the economy. The Federal Reserve had to make the currency elastic again. (Paulson could not make the currency elastic again by borrowing money already in the economy and moving it around)

The author also tried numerous times to explain all this to the Federal Reserve, specifically to the members of the FOMC. Eventually, the Federal Reserve started replacing the lost money with its idiotically named QE programs. Once the lost money was replaced and the currency was elastic again the economy resumed its normal shape after contraction and the Great Recession ended. 

What is important to note here is that this author pointed out the solution to the Great Recession long before the Federal Reserve ended up doing exactly what the author said it needed to do to end the crisis. The author understood the solution to the Great Recession because he understands exactly why the Great Depression occurred as explained above. All depressions and recessions occur for the same reason.

Had the Federal Reserve done what it is specifically charged to do at the very beginning of the Federal Reserve Act, create an elastic currency, the Great Recession would not have occurred or it would have been over very quickly. The same is true for the Great Depression (and every recession since the Federal Reserve was created in 1913).  (4)

The author would be extremely remiss if he did not say one more very important fact here. Deflation can occur naturally in an economy but not inflation. The idea behind creating the Federal Reserve was to prevent naturally occurring deflation. It was never to have the Federal Reserve itself create any deflation or inflation. 

Only the Federal Reserve can create inflation in the United States economy. Whenever inflation occurs in the United States economy it is always the work of the Federal Reserve. (5)

1. Many people try to blame a whole host of reasons why the Great Depression happened but the only thing unique and specific to the time is how much money disappeared from the economy.

Some have blamed the Smoot-Hawley tariffs for causing the Great Depression. While the tariffs did not help they certainly did not cause the Great Depression.  In 1828, tariffs larger than Smoot-Hawley were passed with no resulting Great Depression. Tariffs do not directly cause money to be lost from an economy.

Some have blamed higher taxes for the Great Depression. Again, higher taxes are never good for any economy but many other times in United States history taxes have been higher with no resulting Great Depression. Higher taxes do not directly cause money to be lost from an economy.

If the same percentage of money disappeared from the economy today as happened in the early 1930s, we would have another Great Depression. Due to many different factors including the work of this author another Great Depression is highly unlikely.

2. The author has often wondered if a failed company or even individuals could have sued the Federal Reserve during the Great Depression for failing to follow the very first reason for creating the institution. Not only did the Federal Reserve not create an elastic currency it did the opposite and created an inelastic currency. 

If a government created institution not only fails to do what it is chartered to do but does the exact opposite and you suffer grievous financial losses due to its inaction and actions do you have grounds for a lawsuit?  

3. Why did the Federal Reserve keep selling assets at that time? The simple answer is they had no understanding of what they were doing or how an economy works. 

In real terms, the only assets not declining in value at the time were governments bonds. So the Federal Reserve forced the banks still in existence to keep buying government bonds from them to try and shore up their balance sheets.

Of course it was the Federal Reserve's own actions (draining money out of the economy by selling government bonds) that was causing all other asset prices to plummet in value which was wrecking the balance sheets of the banks.

4. Recessions occur when money gains in value and people and business slow their spending as a result. If money gains enough in value a recession will turn into a depression. 

5. Theoretically inflation can occur naturally in an economy but it will be self-corrected in short order. Deflation will also be self-corrected in an economy but it takes longer. That is for economies operating without a Federal Reserve.

© Joe Dorish 2018-2019