No economic event in the 20th century had a greater impact on people and institutions than the Great Depression, which arguably was responsible for the ascension of Adolf Hitler (and, by extension, World War II and the Holocaust), the rise of the modern welfare state, and a revolution in the way scholars understand the economy. Why did the Great Depression occur? Why did it last so long? Why did some countries have a much milder and shorter downturn than others? Are there lessons to be learned from the Depression that apply to similar downturns, like the one we are in now?

The scholarly evidence, once seemingly supportive of activist governmental fiscal and monetary policies, has increasingly shown that Depression-era governmental activism likely prolonged (and perhaps even caused) the downturn. Thus an objective reading of the Depression story makes one decidedly pessimistic that President Obama's policies of massive budget deficits, stimulus packages, huge interventions in financial markets, and major structural changes in the economy (via health care reform and so-called cap and trade bills) will have positive effects on the economy in years ahead. Parallels between Franklin Roosevelt's New Deal and the Obama Administration's agenda are often uncanny: in 1933, government officials promoted the killing of six million pigs to help agriculture; in 2009, the Obama administration promoted the "killing" of 250,000 older automobiles (Cash for Clunkers) to help the auto industry.

In this connection, it is instructive to compare the 192022 downturn with the one beginning in 1929. For the first seven quarters, the 192022 cyclical decline was by most measures slightly more severe than the one beginning in late 1929. Yet the earlier downturn elicited little government action: President Woodrow Wilson was too incapacitated by a stroke to manage major policy innovations. Warren G. Harding, who assumed office in March 1921, was opposed to intervention, and aided by conservative Treasury Secretary Andrew Mellon, he cut government spending and returned the government to a healthy budget surplus. Within a year or so, the economy was rebounding. By contrast, in the 1929 downturn, the federal government tried to manipulate wages upward, enacted the highest tariff in American history, and undertook huge public works projects, major new social programs (e.g., Social Security), and comprehensive regulation of wages, prices, and working conditions (the National Industrial Recovery Act). Yet the unemployment rate exceeded 10% for a decade. The non-activist policy response of 192022 was decidedly more effective than the activist one of 192930.

Scholarly attitudes towards the Depression have gone through three distinct phases: Neoclassical/Austrian (19291935), Keynesian (193670), and Post-Keynesian (1970 to the present).

Pre-Depression Orthodoxy

Before the Depression, there was surprisingly little discussion about business cycles and their cure. The word "unemployment" did not even exist until the 1880s. At the time of the Great Depression, English-speaking economists were heavily influenced by the work of Alfred Marshall (18421924), whose most prominent disciple was probably A.C. Pigou (18771959). Pigou's Industrial Fluctuations (1927) and The Theory of Unemployment (1933) summed up the neoclassical perspective: by definition, unemployment occurred when the quantity of labor supplied exceeded the quantity demanded, which occurred when wage rates were too high to fully employ workers (even allowing for unemployment short in duration or resulting from people changing jobs).

The most famous American economist at the time, Irving Fisher, was interested in monetary phenomena with implications for business cycles, but he did not emphasize those cycles in his work and erred famously when he opined in the fall of 1929 that the "stock market has reached…a permanently high plateau."

In his classic works Theory of Money and Credit (first published in German in 1912) and Human Action (1949), the Austrian economist Ludwig von Mises argued that downturns reflected distortions in prices (especially interest rates) from their natural rate, and that governmental manipulation of the money supply or use of fiscal policy stimulus was counterproductive. His brilliant disciple Friedrich Hayek extended Mises's insights in such works as Monetary Theory and the Trade Cycle (1929) and Prices and Production (1931). In the Mises-Hayek interpretation, as later articulated by Murray Rothbard, the Federal Reserve, in its first peacetime exercise of power, expanded the credit supply excessively in the mid- to late 1920s, pushing interest rates below the rate of interest that would have emerged naturally from individual tradeoffs between saving and consumption. This led to "malinvestment" in the form of a housing and consumer durable goods boom that was ultimately not sustainable and led to the stock market crash in '29. Consistent with the Austrian view that price distortions induced by the central bank caused the depression, Hayek's London School of Economics colleague Lionel Robbins wrote an early critique, The Great Depression (1934), in which he argued that abnormally high wages contributed to the downturn.

Even after Keynesian economics reigned supreme, market-oriented economists continued to make their case, as in Benjamin Anderson's Economics and the Public Welfare (1949), W.H. Hutt's The Theory of Idle Resources (1939), and Murray Rothbard's America's Great Depression (1963).

Keynes and Keynesianism

In 1936, the early Neoclassical/Austrian perspective was swept away by the publication of John Maynard Keynes's The General Theory of Employment, Interest and Money, the most influential work in economics in the 20th century. Keynes argued that insufficient aggregate demand (underspending), rather than high wages or distorting central bank policies caused major downturns, especially the Great Depression. Keynes was brilliant, persuasive, and a master of what Deirdre McCloskey calls "the rhetoric of economics," which so often triumphs over either dispassionate empirical evidence or superior theoretical frameworks.

Keynes popularized what became known as the "multiplier" effect (an increase in government spending will lead to a larger increase in national income) and the "paradox of thrift" (too much saving will lower aggregate demand, national income, and, thereby, the amount of savings). Keynes's young disciple Paul Samuelson added the "accelerator principle," showing how small changes in investment spending can have magnified effects. Keynes's work was in some sense anticipated in the 1920s by the English economist John Hobson and American writers W.T. Foster and Waddill Catchings, but Keynes's theory was far more comprehensive and seemed to explain the problems of the time.

A Keynesian explanation of the Great Depression starts by observing that an increasingly unequal distribution of income in the 1920s led to rising savings—mainly among the affluent—that were invested in the stock market and produced a consequent decline in spending on consumer durable goods and housing. The stock market, over-valued because of speculation fueled by massive investments by wealthy Americans and loans from banks, started plummeting in the fall of 1929. As stock prices fell, panic ensued. Consumers drastically cut spending and, perhaps more important, businesses sharply reduced investment. The Hoover Administration, and later the Roosevelt Administration, failed to follow a vigorous fiscal policy of deficit financing that could have stimulated aggregate demand. Although some New Deal efforts—e.g., the Works Progress Administration—were, on balance, job creating, they were financed by higher taxes, or counteracted by budget surpluses of state and local governments. When the United States entered World War II and truly massive deficit-financed government spending was finally undertaken, however, unemployment plunged and the Depression ended.

Keynes died in 1946, but others expanded on his ideas. Alvin Hansen wrote of "secular stagnation"—how the close of the frontier and slowing of population growth led to a fall in American economic growth. Abba Lerner looked at the policy implications of Keynes's work, stressing the idea of "functional finance"—using budget deficits as a tool to achieve economic stabilization. Lawrence Klein's Keynesian Revolution (1947) influenced a generation of graduate students. Samuelson brought Keynesian ideas to generations of undergraduate American college students through his textbook,Economics (first published, 1948), widely imitated by other economists.

Keynes's work, however, was more of a theoretical treatise than an explicit explanation of the Depression. Empirical support for his ideas was surprisingly skimpy. E. Cary Brown authored an influential 1956 American Economic Review paper arguing that expansionary Keynesian-style fiscal policy was essentially not used in the 1930s—hence the downturn's length and severity. John Kenneth Galbraith popularized Keynesian ideas with books like The Great Crash, 1929 (1954), which were long on anecdotes but short on empirical evidence. Major biographies of FDR, such as Arthur Schlesinger, Jr's,The Age of Roosevelt (195760) and James MacGregor Burns's Roosevelt: The Lion and the Fox (1956) implied that activist government policies alleviated both the downturn and human distress. Later, Peter Temin used more serious empirical evidence in Did Monetary Forces Cause the Great Depression? (1976) to suggest that aggregate demand did in fact plummet (mainly because of declining consumption and exports), that monetary policy was ineffective, and, by implication, that aggressive Keynesian-style fiscal stimulus could have ameliorated the 1929 downturn.

Rise of the Monetarists

The Keynesian explanation of the depression, however, began to fade—very slowly in the late 1960s and early '70s, but faster after vigorous Keynesian-style deficit spending failed to prevent the stagflation of the 1970s. The key work igniting the post-Keynesian interpretation was Milton Friedman and Anna Schwartz's magisterial A Monetary History of the United States (1963). The authors revived Irving Fisher's quantity theory of money, the intuitively compelling notion that changes in price levels have to do with changes in the amount of money in circulation. Friedman and Schwartz demonstrated, too, how changes in the stock of money are closely associated with boom and bust cycles, and that the Great Depression's chief cause was the Federal Reserve's failure to prevent a roughly one-third decline in the money stock between 1929 and 1933. At the onset of the Great Depression, the Fed did not serve as a "lender of last resort," and instead let thousands of banks fail. It made very bad decisions, like raising the discount rate in 1933 when unemployment exceeded 25% (making it more costly for banks to borrow from the Fed and thus restricting credit), because of a fear of capital flowing abroad. Within a month President Roosevelt had to close all the banks to prevent systemic breakdown. The Fed had done too little too late.

Contrary to the Austrian and other early interpretations, Friedman and Schwartz thought the problem was poor stewardship of price stability by the central bank, rather than distortions in relative prices (including interest rates). The Keynesian framework, however, was well entrenched in the economics profession, and was enhanced by the work of an obscure New Zealand economist, William Phillips, whose "Phillips Curve"—christened in 1958 and partly redefined later by Robert Solow and Paul Samuelson—suggested that increases in prices (presumably induced by fiscal or monetary stimulus) were associated with falling unemployment. During the early 1930s, prices fell and unemployment rose, consistent with the Phillips curve. The Keynesian solution would be to inflate the economy—mostly by more government borrowing and spending (since monetary policy was considered ineffective), raising aggregate demand and thus prices, and consequently reducing unemployment.

Friedman was hostile to this formulation. In 1967, in his presidential address to the American Economic Association, he outlined what became known as the "natural rate" thesis. Unemployment has some "natural" rate that prevails when actual and expected inflation rates are the same. Deviations of inflation from the expected rate are responsible for a good deal of fluctuations in unemployment and output. In the long run, you cannot fool all the people all of the time—their expectations change in a way that renders stimulus policies ineffective, and thus inflationary spending loses its potency. Edmund Phelps reinforced and augmented this view in his important book, Microeconomic Foundations of Employment and Inflation Theory (1970).

Robert Lucas, Thomas Sargent, and others morphed the Friedman-Phelps view into an even more radical form of economic theorizing: "rational expectations" or New Classical economics. In its extreme form, the theory suggests that any policy action of the government (e.g., Keynesian-style fiscal policy) will be completely and almost immediately offset by the behavioral changes of individuals who might be adversely affected by the policy change. Although this theory in itself did little to explain the Great Depression, it increased skepticism towards the mid-century Keynesian view that the Depression reflected under-spending by consumers and investors that could have been mitigated by prompt, aggressive policy.

Against the Keynesians

The pre- and post-Keynesian skeptics have received considerable support in recent decades. My book with Lowell Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America (first published, 1993; updated and expanded, 1997) argued that unemployment in the 20th century was inversely related to the "adjusted real wage," i.e., wages adjusted for inflation and productivity change. In our view, the Great Depression resulted largely from Herbert Hoover's and FDR's poorly conceived but successful effort to keep businesses from reducing wages—through such wage-enhancing policies as the Smoot-Hawley Tariff in 1930, the National Industrial Recovery Act (NIRA) in 1933, and the Wagner Act in 1935. Indeed, the banking crisis after 1930, in our view, reflected deterioration in bank balance sheets and a resulting loss of confidence that originated in the adverse financial consequences of Hoover's high wage policy. Some research by Ben Bernanke published in his Essays on the Great Depression (2000) is consistent with this hypothesis. Other work, notably William Barber's From New Era to New Deal (1989), clearly documents Hoover's obsession with promoting high wages as a solution to insufficient aggregate demand. Yet not all scholars agree: Bernanke argued that "maybe Herbert Hoover and Henry Ford were right; higher real wages may have paid for themselves in…that their…effect on aggregate demand compensated for their tendency to raise costs."

The Vedder-Gallaway view has been reinforced by Harold Cole and Lee Ohanian's important 2004 article in the Journal of Political Economy, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis," which demonstrates that wages and prices were grossly distorted upward by the NIRA's perverse effects. The Depression could have ended seven years earlier in the authors' judgment. Ohanian has more recently reinforced the Vedder-Gallaway position that high wages induced by government policy under Hoover dramatically increased the scale of the downturn.

The attack on Keynesian conventional wisdom has come from several other quarters as well. For example, Robert Higgs has emphasized something contemporary observers of the New Deal spoke about often: American businessmen for the most part loathed and feared Franklin Roosevelt's fiery anti-business speeches, high taxes on incomes and profits, and stringent regulations. This "regime uncertainty" dramatically reduced investment spending, an issue Michael Bernstein explored in The Great Depression: Delayed Recovery and Economic Change in America 1929-1939 (1987). The fall in confidence that some Keynesians believe was important in explaining the post-1929 decline may, in fact, be a better explanation of the downturn's long duration, and was due more to a lack of confidence brought on by fear of government than anything endemic to the market-based financial system.

Several other interpretations of the Depression have likewise been far more critical of Hoover and Roosevelt than was typical in the era of Keynesian ascendancy. Gene Smiley's short, trenchant critique, Rethinking the Great Depression(2002), highlighted policy failures ranging from the Smoot-Hawley tariff and "soak the rich" tax increases to everyone's favorite target, the NIRA. Most recently, Amity Shlaes's The Forgotten Man (2008) cleverly used vignettes from the lives of Depression-era men and women to show some of the New Deal's negative consequences. In general, presidential biographers have grown more critical of New Deal policies over the years, a judgment almost certainly to be manifested in Alonzo Hamby's forthcoming biography of FDR.

International Factors

To be sure, supporters of the traditional Keynesian interpretation still exist. The indefatigable Peter Temin continues to write treatises such as Lessons from the Great Depression (1989), stressing aggregate demand explanations, and emphasizing international dimensions of the crisis. Not surprisingly, Hoover himself thought external forces were responsible for the downturn.

Temin's emphasis on international factors is not unique. In Golden Fetters: the Gold Standard and the Great Depression(1992), Barry Eichengreen has written extensively on the gold standard's allegedly perverse role in creating and maintaining a worldwide depression. Eichengreen extends the internationalist explanation offered by Charles Kindleberger inThe World in Depression (1973). These writers generally accept a Keynesian framework, arguing that the gold standard prevented activist fiscal and monetary stimulus that could have moderated decline.

Under a gold standard, nations were obligated to redeem their currency with gold. If a nation imported more than it exported, or massively invested abroad, it would typically be forced to use gold to help pay for those goods or investments. As gold stocks became small, nations wanting to remain on the gold standard would have to make imports less attractive, typically by lowering domestic prices (usually through restrictive monetary and fiscal policies). Thus a nation's ability to engage in monetary and fiscal stimulus—much loved by Keynesians—was severely restricted. Using Phillips Curve-like reasoning, it was argued that deflationary policies implemented to defend the currency under the gold standard contributed to the deflation that led to rising unemployment.

Tariffs and protectionism had international repercussions, too. Economists of all stripes have derided international trade's precipitous decline during the Depression—with over a thousand economists denouncing Smoot-Hawley at the time—and continue to regard that decline as at least a secondary cause of the downturn. Retaliatory action by other nations added to the policy-induced fall in international trade. Some writers attribute spillover effects from European financial crises (e.g., the failure of Austria's Credit-Anstalt Bank in 1931) as contributing factors in the near collapse of the U.S. financial system.

The Keynesian approach received an important boost in 2008 in the American Economic Review, where Gauti Eggertsson argued that "regime change" by Franklin Roosevelt's inflationary monetary policy and fiscal stimulus served to bring about recovery from 1933 to 1937. My guess is that Eggertsson's paper will prompt many skeptical scholars to question whether meaningful recovery occurred and, even if it did, whether FDR's activist policies were responsible.

Policy Analysis

Much of the criticism of 1930s government activism is at the micro level, in the form of detailed studies of specific policies. Of particular interest is the research into the National Industrial Recovery Act, which received at best only mixed reviews even in early, favorable accounts. The legislation did two important things: First, it created a Public Works Administration (PWA) that in 1935 morphed into the Works Progress Administration (WPA). Second, it attempted to raise prices to return firms to profitability, and—contradictorily—it tried to raise wages to stimulate aggregate demand. In the midst of more than 20% unemployment, wages soared in the last half of 1933 as firms displaying the "Blue Eagle" (and thus eligible to participate in the price-fixing cartel) were required to meet minimum wage standards that were high for the time.

The NIRA's public works proceeded from the same rationale as President Obama's 2009 stimulus package. The 1930s experience is instructive. At its peak in March 1939, the WPA employed 3,000,000 workers (equivalent to ten million in today's larger labor force), but the unemployment rate using standard Bureau of Labor Statistics definitions was still estimated to be an extraordinary 19.3%. This was nearly six years after the NIRA's passage, and after unemployment in much of Europe had fallen back to pre-Depression levels, despite relatively less frenzied governmental action (for example, British unemployment in 1938 stood at 13.3%, compared with 22.5% in 1931 and 11% in 1929). For every job allegedly created by PWA/WPA, part or all of another job was lost from the indirect effects of the legislation, including the higher taxes called for to support such programs: the highest marginal federal income tax rate rose from 24% in 1929 to 79% by 1936.

Moreover, studies beginning with Gavin Wright's "The Political Economy of New Deal Spending: An Econometric Analysis" in the February 1974 Review of Economics and Statistics demonstrated that New Deal "stimulus" largesse was distributed with political considerations foremost in mind. Some poor, reliably Democratic areas in the South received less than relatively well-to-do swing states that the Roosevelt Administration wanted to win over. A comprehensive study in 2003 by Price Fishback, Shawn Kantor, and John Wallis concluded, "For all programs, spending for political advantage in upcoming elections was a significant factor." It is hard to believe that the Obama Administration learned the economic lessons from the New Deal's stimulus efforts but failed to learn the political ones.

This tour de horizon is necessarily abbreviated, neglecting leading scholars writing about various aspects of the Depression. Nor have I touched on the often unintended effects of the New Deal on specific groups of people. One example worth citing: David Bernstein's Only One Place of Redress (2001) shows that New Deal labor laws and court decisions often had disproportionately bad effects on African-Americans, thwarting the beginnings of their progress in obtaining relatively well-paying and skilled jobs.

Forgotten Lessons

The Great Depression has become the leading academic battleground for alternative perspectives on economic stabilization. Careers are often solidified by Depression-era research. Had Ben Bernanke not done lots of research on the Depression, would he be Federal Reserve Chairman today? I doubt it. Thus academic scholarship on one economic crisis has produced a major actor concerned with the resolution of another one. Academics thrive and prosper from their disagreements, so it is unlikely that a universally accepted explanation of the Depression will ever evolve from the assorted and often contradictory views of contemporary scholars.

Nevertheless, the once popular notion that the Great Depression is a frightening object lesson in the fragility of markets and the failings of free enterprise has receded considerably, and the alternative notion that mistaken or misbegotten government (including Federal Reserve) policies prolonged and deepened the misery has grown in importance. Unfortunately, however, it seems in an age largely ignorant of the past, every couple of generations we have to relearn the forgotten lessons of earlier times. The tragedy of current federal activism in the name of economic recovery is that our nation's leaders have either forgotten, or ignored, the accumulating evidence that government efforts to heal sick economies are usually failures.