Deflation and the 1930s

Deflation refers to a condition where prices decline over a period in time. The prevailing view amongst economists is that deflation can be the cause of many problems in an economy.

This opinion primarily arose in the aftermath of the Great Depression in the 1930s. It is therefore instructive to review what happened during that time. As you will see, the likely cause of the economic woes was not consumer price deflation per se, but primarily a banking crisis brought about by an asset price bubble. The resulting shrinkage of the money supply eventually led to falling consumer prices.

Antecedents of the 1930s Depression

The epicentre of the Great Depression was the US. Although the ripple effect of the economic collapse of that nation affected the globe, it is important to understand what was happening in that country in the preceding decade to fully appreciate the true causes of the calamity.

Also known as the “Roaring Twenties”, the 1920s were a period of massive expansion of wealth in the US where it more than doubled between 1920 and 1929. Estimated GDP grew over 13 per cent in 1923 alone. The period was associated with increases in consumer spending and mass consumption of products for the first time e.g. fridges and automobiles. For some, it was also an era with constant parties, jazz and a flapper lifestyle.

Much of this was a result of changes in the banking industry. The newly formed Federal Reserve oversaw a rapid rise in lending for property and the phenomenon of national banks transforming themselves from institutions that simply held money into organisations selling a wide variety of investments. Banks leveraged their databases of account information to target sales of bonds and (later) shares to the public.

Clients’ investments were encouraged by the concept of margin. It was only necessary to put up 10 per cent of the purchase price of shares, the rest being supplied as a loan by the bank. All this caused a public frenzy of stock market activity, driving asset prices higher and higher until the bubble finally burst in late 1929. At that point, the Federal Reserve tried to rein in the bubble by raising interest rates.

The early 1930s in the US

Although stock prices recovered in early 1930, they then declined again and by mid-1932 had dropped nearly 90 per cent. Many ordinary people lost fortunes in the stock market over this period. As noted above, many had bought shares on margin and went bankrupt. The resulting tidal wave of defaults brought down many banks. In the runs on those banks even more money was lost by ordinary people.

At the same time, the remaining banks tried to rescue their balance sheets by calling in loans (especially to business) which further shrank the economy. Business confidence collapsed, as did spending. Overall money supply contracted by over a quarter between 1930 and 1933, as money was destroyed in all these ways.

The whole situation was made even worse by a natural catastrophe. Between 1930 and 1936, droughts hit the main prairie lands of the US and turned them into a dust bowl. Not only did this create massive unemployment and poverty amongst migrant workers but farmers had to abandon their farms, unable to pay back the debt on them. This led to further bank failures and made the banking crisis even worse.


Source: “8b33132r” by Dorothea Lange – United States Library of Congress’s Prints and Photographs division under the digital ID fsa.8b33132. Licensed under Public domain via Wikimedia Commons.

US unemployment soared to 25 per cent by 1933 and consumer spending was drastically hit. Not only was a large portion of the population living on subsistence having been made unemployed, but those still in work often experienced pay reductions. Those with any remaining cash after the bank failures tried to keep what wealth they could and reduced their expenditure.

The velocity of money therefore also reduced. The resulting decreased demand not surprisingly led to lower prices, as producers and retailers sought to compete for what sales they could. Deflation set in. Consumer prices declined a quarter by 1933, with commodity farm prices declining even more.

However note the causality here. As discussed before, it was not deflation that created the economic problems of the 1930s. It was an outcome of the banking crisis and reductions in asset prices that had caused the overall money supply to shrink.

The Fed’s response

At the height of the crisis, the Federal Reserve initially took a non-interventionist position. Many at the Fed believed that the correction seen in asset prices and the resulting foreclosures of unprofitable businesses were nature’s way of correcting imbalances and that after a period of pain the economy would recover.

The crisis was a bigger one than had been witnessed before in previous business cycles and its impact was greater. There was therefore heavy political pressure to do something. However the Fed was restricted at that time in its ability to create money by the requirement that 40 per cent of its assets should be backed by gold. So apart from reducing interest rates to help borrowers, it did little to try and alleviate the misery. Instead it was up to presidential initiatives by Hoover and Roosevelt to aid the recovery. A full recovery only came after the advent of World War II.

The debt-deflation theory

Since then there has been much analysis by economists of the Great Depression, why it happened and whether more could have been done to alleviate its affects. A key economist of the time was Irving Fisher. He proposed the debt-deflation theory. In this he argued that there was a chain of events that created the crisis. It started with debt liquidation and distress selling. This contracted the money supply as bank loans were paid off, which led to a fall in the level of asset prices. This resulted in a still greater fall in the net worth of businesses, precipitating bankruptcies and a decline in profits. This created a reduction in output, in trade and in employment. At the same time there was an overall loss of confidence causing people and businesses to hoard money.

Debt deflation theory

This key issue with this theory, which became very influential, is that it links the word deflation in economists’ psyche with economic trouble. That is despite the fact that the deflation refers primarily to a reduction in asset prices and not consumer prices. It has subsequently become associated with a situation where the prices of ordinary goods and services decline, even though there was little reference to consumer price deflation in the original theory.

Ben Bernanke and deflation

Fisher was particularly influential on the thinking of an economist called Ben Bernanke in the 1980s.  He not only published his own theories on the causes of the Great Depression but went on to become chairman of the Federal Reserve from 2006-2014 and oversaw the handling of a re-run of the 1930s banking crisis in the post 2007 era.


Source: “Ben Bernanke official portrait” by United States Federal Reserve. Licensed under Public domain via Wikimedia Commons

Bernanke believed that the Federal Reserve was largely responsible not only for creating the Great Depression by trying to curtail the asset boom, but also for ensuring that it lasted so long and was so painful by not helping to alleviate the symptoms. These views very much followed those proposed by the economists Milton Friedman and Anna Jacobson Schwartz in 1963.

A key part of Bernanke’s theory was that deflation reduced the value of the collateral of assets used against bank loans (for mortgages or by business). This increased banks’ risk on those loans and caused them to foreclose on them. He postulated that deflation was so bad because it ‘dammed’ the flow of credit in the economy.

The effects of deflation are complicated. Bernanke is probably right that it affects credit flows in the economy. It certainly has an impact on debtors. However, for the vast majority of the population, steady or slightly declining prices are not an issue and can indeed have benefits. These benefits are often ignored in the economic debate, which primarily uses the 1930s as its framework for analysis.