Answer:
The Great Depression was caused by government intervention, above all a financial system controlled by America’s central bank, the Federal Reserve — & the interventionist policies of Hoover & FDR only made things worse.
The precise causes of the Great Depression remain a subject of debate, although, as economist Richard Timberlake observed n 2005, “Virtually all present-day economists... deny that a capitalist free-market economy n any way caused” it.
At the time, however, the free market was blamed, with much of the ire directed at bankers & speculators. Financiers were seen as having wrecked the economy through reckless speculation. President Hoover came to be viewed as a laissez-faire ideologue who did nothing while the economy fell deeper & deeper into depression, & Franklin D. Roosevelt’s interventionist policies under the New Deal were credited with rescuing us from disaster.
Americans came to conclude that the basic problem was the free market & the solution was government oversight & restraint of financiers & financial markets. It’s a view that the public, unaware of the consensus of modern economists, continues to embrace.
But the conventional story ignores the elephant n the room: the Federal Reserve. To place the blame for the Great Depression on a free financial system is like placing the blame for the fall of Rome on credit default swaps: you can’t fault something that didn’t exist. & by the time of the Great Depression, America’s financial system was controlled by the Fed.
It’s hard to overstate the importance of this fact. The Federal Reserve isn’t just any old government agency controlling any old industry. It controls the supply of money, & money plays a role n every economic transaction n the economy. If the government takes over the shoe industry, we might end up with nothing but Uggs & Crocs. But when the government messes with money, it can mess up the entire economy.
The two deadly monetary foes are inflation & deflation. We tend to think of inflation as generally rising prices & deflation as generally falling prices. But not all price inflation or price deflation is malignant — & not all price stability is benign. What matters is the relationship between the supply of money & the demand for money — between people’s desire to hold cash balances & the availability of cash.
Economic problems emerge when the supply of money does not match the demand for money, i.e., when there is what economists call monetary disequilibrium. Inflation, on this approach, refers to a situation where the supply of money is greater than the public’s demand to hold money balances at the current price level. Deflation refers to a situation where the supply of money is less than necessary to meet the public’s demand to hold money balances at the current price level.
N a free banking system, as George Selgin has argued, market forces work to keep inflation & deflation in check, i.e., there is a tendency toward monetary equilibrium. Not so when the government controls the money supply. Like all attempts at central planning, centrally planning an economy’s monetary system has to fail: a central bank has neither the knowledge nor the incentive to match the supply & demand for money. & so what we find when the government meddles n money are periods where the government creates far too much money (leading to price inflation or artificial booms & busts) or far too little money (leading to deflationary contractions).
& it turns out there are strong reasons to think that the Great Depression was mainly the result of the Federal Reserve making both mistakes.
The goal here is not to give a definitive, blow-by-blow account of the Depression. It’s to see in broad strokes the way in which government regulation was the sine qua non of the Depression. The free market didn’t fail: government intervention failed. The Great Depression doesn’t prove that the financial system needs regulation to ensure its stability — instead it reveals just how unstable the financial system can become when the government intervenes.
