Saturday, April 11, 2009

How did the Federal Government and the Federal Reserve make the Great Depression worse in the 1930s?

I have heard that the government and the Federal Reserve made the depression worse by intervening in ways he shouldn't have.

In what ways did Hoover's administration cause the depression to worsen?


Hoover and Roosevelt were the reason why the Great Depression lasted for more than a decade!

Prior to 1929, depressions lasted only a year or 2 as the government allowed the market to correct itself, it was painful but short. The Great Depression lasted more than a decade because of all the government intervention that the Hoover and Roosevelt administrations did. They thought that a "few central planners" are more knowledgeable than the market itself so they created their "new deal". History showed that they were dead wrong. Because of all the government intervention that they did during the 30s, the market was not able to correct itself and it made the matters worse.

To explain it further, let us talk about the business cycle:

Entrepreneurs are the expert in predicting the market, thus they can venture into capital investment and business decisions. Some of them fail because they are not as good as those who are successful. But if the market is tampered with by the government (through artificially low interest rates, price fixing, wage fixing, inflation, etc), it sends bad signals to these entrepreneurs which causes them to make bad investments (malinvestments) - and a temporary/fake prosperity ensues (this is the boom cycle). Once the market tries to get back to real rates or equilibrium, it will start liquidating the malinvestments created by the boom cycle (this is the bust cycle).

A perfect analogy would be the following:

Imagine a small landowner who rents out a space for lodging in a small town. One day, the circus came to town bringing with it its numerous staff and the tourists they attract. Because of this, more demand came up for his business. He then started buying the lots beside his land and created more lodging for the people that the circus attracts. Once the circus leaves town though, not only did it bring its staff with it, its departure also stopped the big number of tourists coming into town. Now the business owner is paying extra expenses for very few customers.

So, the business cycle exists because of government intervention and NOT by the free market.

Now that we do have a business cycle because of the federal reserve, the best thing to do during depressions is just to let the market correct itself because that is what is needed to remove the malinvestments. Depressions are the corrections needed by the market. And by stopping these corrections from happening, it makes the matters worse. That is exactly what the Hoover and Roosevelt administrations did during the Great Depression. That is the reason why the depression lasted for more than a decade.

***The gold standard did not cause the great depression.

The dollar was pegged to gold for two hundred years and the world was on a "gold standard" up until 1971. Then, after WWII, we convinced the other nations to get off the gold standard in favor of a dollar standard (Bretton Woods system). In effect telling the world that "we have all the gold and you can convert your currency into dollars and redeem your gold whenever you want". But due to the inflationary methods of the government (increase in supply of money), we basically printed up so much dollars that the gold in the US started to dwindle when foreigners started exchanging their dollars into gold (because they found out that the dollar was losing its value due to inflation). Because of that, the government "closed" the "gold window" to prevent further loss of gold from the US' reserves. Then, the dollar lost two-thirds of its value BUT it remained the world's reserve currency (at a lower value, without a gold backing)

Now we are seeing more and more of the destruction of the dollar because of its debasement through inflation. This may be one of the final straws that may crush the dollar. If the government will not return to sound money, the crash of the dollar would not be a matter of "if" but a matter of "when".

The biggest cause of the Depression and its perpetuation was the gold standard. Countries that abandoned gold recovered. The United States was the last to abandon gold, so it took the longest to recover and its effects were worse here than anywhere else.

Proximate to the Hoover Administration, at the outside the Federal Reserve Bank of New York acted to defend the economy, but did so in politically unpopular ways. It was doing what the government is doing right now. The Board of Governors acted against the New York Fed and the White House defended gold and laisse faire. In normal functioning markets this would have been a good thing to do. In market failure the supply and demand curves do not meet anymore and so prices are very inefficient and cannot become efficient again on their own. Serious government intervention is need to force the curves to meet again. They worsened it by increasing tariffs, reducing spending, defending gold and by staying out of the market place.

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