Classical View of Depression
Why did FDR turn to the New Economists, and not the classical economists or people who accepted their view? He felt that the people who still accepted classical economics had to little to offer by way of advice, other than suggesting that Hoover was handling the situation correctly by insisting the government should have no involvement. Basically they wanted to pretend the Depression was not happening, which FDR correctly saw was a politically unviable view. He felt that the only people who were offering advice on a role for government which might be able to do something about the Depression were the New Economists.
The classical economists, in all honesty, were baffled. The way the economy was supposed to work, according to classical economic theory was that equilibrium, or a balance, would be achieved between supply, what is produced, and demand, the amount consumed. The classical economists believed this balance would tend to be achieved at or near the point of full employment; meeting demand would require these of most of our productive potential, which meant that everybody or almost everybody had to work if the economy was to produce the needed goods.
Classical economists assumed the economy would go through periodic business cycles. Businesses would produce more than people would buy; supply would exceed demand. Businesses would then cut back production, sending the economy into a downward cycle, or even a depression. Eventually the excess production would be used up; supply and demand would once again be equal. At this point businesses would start gearing up, and the economy would go through an up cycle.
An underlying assumption of this theory was that demand would remain a constant, unaffected by the downturn in the business cycle. When the economy went into a downturn, employers would keep the same number of workers, but cut back their hours. Because demand was a constant, the economy would tend to be self-correcting; there would always be a mechanism to pull the economy out of a downward cycle. When the constant demand used up the over production, when supply once more was equal to demand, then businesses would start producing again, pulling the country into an upward cycle. Because the economy could correct itself automatically in this manner, input from the government was not needed.
The economy had worked this way almost from the beginning of our country. We had gone through business slumps, and even periodic depressions, but the economy had always managed to correct itself without any help from the government. When the country went into the Great Depression, and was unable to pull itself out, the economists were baffled; this had never happened before.
The reason the economy wasn't able to correct itself and pull out of the Depression is that demand had collapsed, instead of remaining constant as the classical economists believed it would. Basically, nobody was buying anything.
There were a number of reasons why demand was able to drop as far as it did. Primarily it was because, demand was weak to start with because our country was in the process of making the transition from an agrarian society to an industrial society.
There are different stages of economic development. The first stage is agrarian; at this stage, most people in the society work in farming. The next stage is the development of basic industrialism. At this stage, a large percentage of the population is involved in farm work, but there are industries as well to satisfy existing needs, such as the need to transport goods, or textiles, for clothing. The next stage is mature industrialism. At this point, very few people are employed on farms; most people work in some capacity in industrialism. As well as satisfying existing needs, industrialism creates and satisfies wants as well; this is a consumer society. To get from the middle stage of agrarianism\basic industrialism to mature, consumer industrialism, a number of conditions must be met. First, a relatively small percentage of the population must be able to meet agricultural needs, in other words it only takes a few farmers to produce all of the food needed. Also, there must be the mass production of inexpensive consumer goods, and there must be a very large consumer market. These last two are co-dependent. It is not feasible to mass-produce inexpensive goods unless there is a large consumer market, and there will not be a large consumer market unless there is mass production of goods; it is only when industrialism is used to meet wants of the population as a whole as well as needs that there will be a sufficient number of industrial jobs to meet the employment needs of the society. Unless a country has reached mature industrialism, there won't be enough jobs for everyone. Basic industrialism, industrialism to meet existing needs, requires a comparatively small percentage of the labor force.
America was in a difficult, transitional stage in the 1920's, due in part to the influence of World War I. When World War I started, Europe turned to America as a source of agricultural goods, and as a result our farm output jumped, due to increased mechanization and the application of new farming techniques to satisfy the increased demand.
Essentially, the war had moved us past the agrarian stage of development. We no longer required as many farmers to meet our agricultural needs. When the war ended, this fact became readily apparent. The European farmers went back to their fields and America was left with large agricultural surpluses. As a result, our farm economy slipped into a depression in the early 20's. Simply put, we had too many farmers producing too many goods. Unfortunately, there were no industrial jobs to absorb the unneeded farmers, because this country had not yet reached mature, consumer industrialism. It was stuck in a transitional stage, beyond agrarianism but not yet to mature industrialism. Consumerism had started, yet it was limited to a comparatively small segment of the population. A situation like this is challenging for any country, and the United States was no exception. There was a large surplus of labor, because the people who were no longer needed in farming were competing for the few available industrial jobs. Consequently, many people were underemployed or unemployed, and wages stayed low because of the competition for jobs.
This was the situation in the U.S. in the 1920's. Demand was soft because we had not yet moved to a mature level of industrialism which could have provided the necessary number of jobs.
Another factor contributing to the unexpected drop in demand was a change in the system; businesses no longer operated the way they did when the classical economists wrote their theories. Classical economists had assumed that during an economic downturn, businesses would keep the same number of workers but that the workers would work fewer hours or for less money. This is why they assumed demand would remain largely a constant, unaffected by the economic cycles, because the number of workers employed would remain a constant.
But by the 1920's businesses no longer worked that way. Instead, during a downturn, businesses would lay off workers. This meant that the number of workers, and thus demand, would fluctuate during a business cycle. When the economy went into a slump, demand would drop as well, and so would be less likely to automatically correct the situation. This had happened to an extreme degree in the Depression, as millions of people were thrown out of work.
So there was a weakness in demand, and then the possibility of fluctuations in demand. However it was the stock market crash and the years of speculation preceding it which were the catalyst for the immense drop in demand which caused the Depression.
There have been periodic depressions practically from the start of this country. Most of these depressions were caused by, or at least triggered by, speculation. Often it happens this way: a speculator makes money by driving up prices. He, or today possibly she, buy goods, drives up the cost of the goods artificially, and then sells the good at an inflated price. Essentially speculators create the impression of false worth, a bubble; more money is being spent, prices are rising, but nothing more is being produced. The bubble creates the appearance of prosperity, instead of producing actual prosperity. Eventually, the bubble bursts. The artificially high prices collapse to a more realistic level, a reflection of the item's true worth. The people who made money are the speculators who sold off their holdings before the prices collapsed. On the whole, everybody else loses money (like the American taxpayers having to bail out the savings and loans).
How does this pertain to the Depression? When the speculators are driving prices up, creating the bubble, the are also apparently increasing demand. Apparently, because in reality they are not adding anything; instead they are simply inflating the economy, and even though they are not producing anymore, and more is not being consumed in physical terms, the impression of inflated production and inflated consumption emerges. It looks like the economy is expanding.
When the bubble bursts, the inflation bursts as well, and the economy goes into collapse. This creates a large drop in demand, which was caused by the period of inflation. This drop is partly an illusion, since it is just deflating artificially high prices, but also there is a tangible loss. Business people base their short-term expectations on the direction in which the economy seems to be heading. If everywhere around them the economy seems to be deflating, it only makes sense for business people to be conservative in their estimates and pull back production; naturally they felt it was better to increase it at a later time than to be overextended in a serious economic downturn. The effect is much the same on consumers. Given the uncertainty a rapidly deflating economy creates, consumers are more likely to scale back purchases to allow a cushion for possible future economic difficulties. So the speculators create the illusion of a downturn when their bubble bursts, which in turn leads to a tangible drop in productivity and demand, and thus a real downturn in the business cycle and sometimes even a depression.
Next: The Great Depression