What Caused the Great Depression? The legislation in the Tariff Act of 1930 had the effect of raising US tariffs on more than 20,000 imported goods. Many economists agree that Smoot-Hawley was a factor in causing the Depression, but some argue that it played only a small part.
The Smoot-Hawley Tariff
International trade was only about 5–7 percent of the economy in 1930. How could it be a big deal to place this teriff on imports?
The reason is that most human activity is built around expectations. You don’t put stew in the crock-pot because you’re hungry now; you put stew in the crock-pot because you expect to be hungry when you return from work. Economic activity is no different. People build things to sell to someone else, and sometimes that someone else is in another country. Investors buy and sell stocks based on what they expect to happen to those companies.
During the time leading up to the passage of Smoot-Hawley, economists and businesses generally agreed that higher tariffs could pose a major problem if the legislation passed.
This is a transcript from the video series International Economic Institutions: Globalism vs Nationalism. Watch it now, on Wondrium.
Stock Market Begins to Slide
Almost immediately after Hoover’s inauguration on March 4, 1929, the tariff bill under consideration expanded to other goods. The House of Representatives passed Smoot-Hawley in the fall. On October 21, 1929, 16 senators who had been blocking the legislation caved under political pressure. They accepted tariffs supporting industries in their own states in exchange for votes in favor of the bill.
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That’s the day the stock market slide began. By October 29, the market had lost a third of its value. That’s a good approximation for how much less investors expected businesses to make relative to what they had thought just one week previously. The Wall Street Journal and The New York Times both ran stories about the stock market crash on one side of their front pages, and the passage of Smoot-Hawley on the other. At the time, people realized that Smoot-Hawley was a big deal.
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Smoot-Hawley wasn’t yet law, though. The House and Senate bills were different; they had to be reconciled before a bill could go to President Hoover for his signature. For controversial bills, this can take time. Bumpy negotiations between the House and the Senate continued through November and December 1929. In May 1930, a letter signed by 1,028 US economists told President Hoover to veto the legislation.
Henry Ford, the auto magnate, spent an evening at the White House trying to convince Hoover to kill Smoot-Hawley. Thomas W. Lamont, then the CEO of J. P. Morgan, described Smoot-Hawley as asinine. At one point, The New York Times even proclaimed Smoot-Hawley dead.
What do you think happened to the stock market about that time? If you think it recovered, then you’d be right. Stocks regained all but 8 percent of their previous decline. Unfortunately, the market reversed course and lost 22 percent as reconciliation legislation advanced in spring of 1930.
The shocks were worldwide. Ten other countries suffered major stock losses about the same time as the US did. Despite having campaigned on farm tariffs, Hoover himself opposed the massive mutation that finally reached his desk in the form of Smoot-Hawley. He called it vicious, extortionate, and obnoxious. True, he’d supported farm tariff legislation. He also promised to work toward international cooperation. He didn’t campaign for anything remotely as big as Smoot-Hawley. Hoover signed the bill into law. He had promised to sign a much smaller bill but felt that promises made shall be promises kept.
International Trade Impacted
Suppose that you are a political leader in another country, and the United States has just imposed a harsh tariff on your nation’s goods so that it’s no longer possible to sell them here. What do you think your constituents will say? How will you react? You’d probably be forced to retaliate with tariffs of your own against the United States.
That’s what happened. Other countries raised their own tariffs in retaliation after the bill became law. International trade promptly, and predictably, crashed.
International trade promptly, and predictably, crashed. In more than 20 countries, imports and exports fell at least by double digits between 1930 and 1931, with an average decline of more than 27 percent, according to data from the National Industrial Board. In the United States, exports collapsed 37 percent, while imports fell by 32 percent.
Today, most experts agree that cutting taxes is a good way to combat economic downturns. They disagree about how to cut taxes, yes. Some argue that sending people cash is the way to go, because the recipients will spend the cash, putting people to work. That fits with Keynes’s idea of aggregate demand driving economic cycles. Others, prefer to cut tax rates. If people can keep more of what they earn, then they’ll probably be willing to work for lower pay, because they’ll end up with the same after-tax income. Employers who might not hire you at a high wage might hire you at a lower one. You’re more likely to find work after a cut in tax rates. People also work more hours and start more businesses if they get to keep more of what they earn. Fans of rate cuts also point to evidence that people tend to save a tax cut in the form of a cash payment rather than spend it. Decide for yourself which side has the better argument. Either way, you’ll have a hard time today finding people to support a tax increase during a recession.
This view had much less support in the 1930s. At the time, the nation wasn’t used to running budget deficits like it is now. President Hoover recommended a big tax hike late in 1931 to close the then current deficit. Congress approved the tax increase in 1932. This reduced personal exemptions, and sharply increased tax rates. The numbers sound laughably small in our era of big government and high taxes, but the tax increases were substantial at the time. The lowest marginal tax rate more than tripled, from 1 1/8 percent to 4 percent. The highest marginal rate more than doubled, from 25 percent to 63 percent. Today, we’re not surprised that this hurt instead of helped. Households had less disposable – -income, spent less, and had less incentive to work. This made the economic contraction worse.
Further Economic Missteps
The response of the Federal Reserve System and other central banks to the contraction was also a big mistake. They didn’t foresee how bad the economy would get. During the collapse, central banks thought that they were running an accommodative monetary policy. They weren’t. They were selling securities and draining funds from the banking system at precisely the time they should have been doing the opposite. You might want to excuse the central bankers because they didn’t have the knowledge and experience that we have now. Dartmouth economist Irwin says that the Federal Reserve Board back then had three members with no training in economics. One was a farmer, another was a politician, and another—Irwin says we don’t know his background. These poor guys didn’t have the data we have now, either. But tight money during a crash was still a big mistake.
A big reason that the money supply was collapsing was that banking was collapsing. About 10,500 out of about 25,000 banks failed in three years. The money supply declined about 30 percent. Why did so many banks fail? Let’s name a few examples. Banks weren’t allowed to branch in those days. If your local economy was good, then the banks in your area were good. But if the local economy was bad, then the bank couldn’t draw on resources from other areas to stay afloat. Banks had all of their eggs in one geographic basket. This is important because the Depression didn’t hurt all areas of the country equally. We tend to think of a two percent decline as everyone being two percent poorer. That’s not the way it works. During the Depression, a lot of the pain was packed into specific areas and industries.
Common Questions About What Caused the Great Depression
The Great Depression was begun by the crash of the stock market in 1929, which led to bank failures, conservative spending, and international tariffs, all of which caused less trade. This was exacerbated by an intense drought that dried up food supplies.