2000-2001 Student Essay Contest
The Great Depression: Could it happen again?
While the strength of the U.S. economy is a current topic
of interest, few worry about a repeat of the Great Depression.
But, could it happen again? Ninth District high school juniors
and seniors grappled with this question in the Minneapolis Fed's
13th annual essay contest. This is the first-place
essay, selected from more than 200 entries.
"The causes lie deep and simplythe causes are hunger in a stomach,
... hunger for joy and some security, multiplied a million times.
? This you may say of manwhen theories change and crash, when
schools, philosophies, when narrow dark alleys of thought, national,
religious, economic, grow and disintegrate, man reaches, stumbles
forward, painfully, mistakenly sometimes. Having stepped forward,
he may slip back, but only a half step, never the full step back."
John Steinbeck, The Grapes of Wrath 1
In 1928, Fred Bell was living the American Dream as a millionaire in
California. In 1929, the same man, now unemployed, humbly stood outside
on the corner of a busy street, selling apples for income. 2 Across the country, millions of Americans experienced losses of their
own, triggered by the stock market crash of 1929 and definitively reinforced
with the failure of their banks. Real gross national product plummeted
30 percent from previous output, and unemployment reached an unprecedented
high of 25 percent.3 Though acting in good faith, the Federal Reserve's tight money policies
spurred the failure of banks across the nation. The loss of resources
incurred was responsible for the severity and length of the era known
as the Great Depression. Fortunately, the knowledge accrued as a result
of the Federal Reserve's actions has served as a basis to rework policies
and redefine monetary approaches. Both structural and attitudinal reforms
with regards to monetary policy ensure that the United States will never
again suffer a catastrophe similar to the Great Depression.
Through a series of misguided policies, the Federal Reserve's
contractionary monetary actions were the ultimate cause of bank failures
and the economic turmoil that ensued. Though the stock market crash
was certainly a shock to many investors, the effects were not substantial
enough to have produced the economic downturn. 4 The real problem began in 1928 when, upset by an increasing amount of
credit expansion used for speculation, the Federal Reserve tightened
monetary policies.5 Between January 1928 and May 1929, the Federal Reserve sold $405 million
worth of government securities and increased the discount rate from
3.5 percent to 5 percent. 6 Because banks purchasing these securities must pay for them from their
reserves, this maneuver effectively decreased the nation's monetary
base. In addition, raising the discount rate made it increasingly difficult
for banks in trouble to borrow money.
The tightened money stock was detrimental to banks experiencing
pressure from the stock market crash in 1929. After watching much of
their wealth disappear in stocks, many Americans like Fred Bell rushed
to their bank to withdraw deposits. Unfortunately, banks operate on
the assumption that not every customer will request their money simultaneously;
though the required reserve ratio is always kept on hand, many deposits
are lent to businesses and are not immediately accessible. This reality,
compounded with the drop in money stock by approximately one-third7 due to the Federal Reserve's securities purchases, meant that banks
could not meet demands for withdrawals. With their ability to borrow
from the Federal Reserve crippled by the new discount rate, 11,000 banks
folded.8 These closures
induced $2.5 billion losses to the very individuals and businesses recently
hit by the stock market crash, causing investment and consumer spending
to fall dramatically.9 Of the subsequent drop in GNP, consumer spending accounted for an unprecedented
one-half of the decline, no doubt due to losses realized from bank failures. 10
Established in response to the detrimental bank runs,
the Federal Deposit Insurance Corp. precludes the possibility of widespread
bank failures by reforming banks and reassuring consumers and businesses.
In 1933, Congress created the FDIC deposit insurance program under the
Glass-Steagall Banking Act. This law guaranteed up to $5,000 in a bank
deposit, which instilled a sense of consumer confidence in banks.11 If insured, struggling banks would be reorganized under new management
and the FDIC would assume losses in assets.12 Insured deposits strengthened banks' safety nets, and since their advent,
they have been successful in preventing bank panics by assuring customers
of the stability of their deposits.13 Though the funding of the FDIC could not support the loss of all deposits
at once, the Act has increased confidence enough to prevent initial
bank failures that were so costly in the early '30s.14 Thus, federal deposit insurance has proven an effective solution to
the type of bank collapses that plagued the nation in the 1930s and
cemented the economy into a state of depression.
Perhaps more lasting than legal reforms, the radical
change in the Federal Reserve's approach to macroeconomic policy prevents
the possibility of the ill-conceived monetary responses destructive
in the '20s and '30s. The founders of the Federal Reserve System operated
under a faulty understanding about monetary theories.15 These misconceptions are mirrored in the Federal Reserve's incorrect
assumption that bank failures were due to mismanagement and were "not
the System's responsibility," ironic, considering the Fed's role in
causing the collapses.16 Due to a lack of comprehensive macroeconomic research, many economists
during the Great Depression mistakenly believed that business cycles
were inevitable, and assistance from financial institutions like the
Federal Reserve was unnecessary.17
Fortunately, among Federal Reserve officials today there
exists a more accurate understanding of banking operations. This new
commitment to bank soundness is exemplified in actions taken during
the [stock market drop] of 1987. Following the fall of the Dow Jones
industrial average, Chairman of the Board of Governors Alan Greenspan
made a public appearance announcing that the Federal Reserve stood ready
to provide liquidity and support to commercial and member banks.18 This approach reversed the economic downturn by improving consumer confidence
and by providing banks with the courage to lend to ailing businesses
and individuals.19 In addition to appropriate policy action, the Federal Reserve has also
altered its view of its responsibilities to the system, indicating in
a 1987 report that officials would "maintain ... commitment to the stability
of the banking system through judicious use of ... deposit insurance
and the discount window."20 In sharp contrast to the hands-off attitude with regards to failing
banks and the increased discount rate of 1929, this mission statement
clearly illustrates a Federal Reserve dedicated to proper monetary action
in the face of a recession.
In light of the banking reforms and improved understanding
of macroeconomic monetary theory, our economic situation is such that
no recession will ever transform into the prolonged agony of the Great
Depression. Businesses and individuals placing savings in banks can
be reassured that should their bank fail, the FDIC will reimburse their
deposits up to $100,000. This faith in the system in turn prevents the
mass bank runs that worsened the situation at the beginning of the Depression.
Federal Reserve officials like Alan Greenspan have exhibited appropriate
and effective monetary responses to fluctuations in the economy, as
opposed to the harmful actions taken by the Fed in the 1920s and '30s.
By assessing the Federal Reserve and banks' actions in the past, we
have ensured that the same mistakes will never be repeated again, and
our country will never have to experience another calamity such as the
1 Steinbeck, John. The Grapes of Wrath. New York: Penguin
Books, 1992, (405-406).
2 Schraff, Anne E. The Great Depression and the New Deal.
New York: Franklin Watts, 1990, (64).
3 "A Debate that Rages On: Why Did It Happen?" Business Week.
3 Sept. 1979.
4 Federal Reserve Bank of Minneapolis. Achieving
Economic Stability: Lessons From the Crash of 1929." Annual
Report, 1987, (12).
5 Federal Reserve Bank of Minneapolis, 5.
6 Hall, Thomas E., and Ferguson, J. David. The Great Depression:
An International Disaster of Perverse Economic Policies. Ann
Arbor: The University of Michigan Press, 1998, (64).
7 Friedman, Milton, and Schwartz, Anna J. A Monetary History of
the United States 1867-1960. Princeton: Princeton University
Press, 1963, (352).
8 Hall, 85.
9 Friedman and Schwartz, 351.
10 Hall, 67-68.
11 Schraff, 26.
12 Friedman and Schwartz, 440.
13 Federal Reserve Bank of Minneapolis, 16.
14 Friedman and Schwartz, 441.
15 Friedman and Schwartz, 407.
16 Friedman and Schwartz, 358.
17 Bernstein, Michael A. The Great Depression: Delayed Recovery and
Economic Change in America. 1929-1939. Cambridge: Cambridge University
Press, 1987, (216-217).
18 Federal Reserve Bank of Minneapolis, 13.
19 Federal Reserve Bank of Minneapolis, 14.
20 Federal Reserve Bank of Minneapolis, 17.