Causes of the Great Depression

Why This Matters

The Great Depression wasn't a single event—it was a catastrophic chain reaction that exposed fundamental weaknesses in the American economic system. Understanding its causes means grasping how speculative bubbles, structural inequality, policy failures, and feedback loops can transform a market downturn into a decade-long crisis. You're being tested on your ability to connect these factors, not just list them.

Don't just memorize that the stock market crashed in 1929. Know why speculation made the crash inevitable, how bank failures amplified the damage, and why government responses often made things worse. The AP exam loves asking you to analyze how multiple causes interacted—so focus on the mechanisms that turned problems into catastrophes.

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Speculative Excess and Financial Instability

The 1920s economy was built on a foundation of borrowed money and inflated expectations. When asset prices rise faster than their underlying value, a correction becomes inevitable—and the higher the climb, the harder the fall.

Stock Market Crash of 1929

• Black Tuesday (October 29, 1929) marked the most dramatic single-day collapse, wiping out billions in paper wealth and signaling the end of the Roaring Twenties
• Speculative buying on margin—investors borrowing up to 90% of stock prices—meant that when values dropped, forced selling created a devastating downward spiral
• Consumer and business confidence collapsed overnight, freezing investment decisions and triggering the psychological shift from boom to bust

Excessive Use of Credit and Installment Buying

• Installment buying allowed consumers to purchase cars, appliances, and homes with small down payments, creating an illusion of prosperity built on debt
• Unsustainable debt levels meant that any economic slowdown would trigger mass defaults, as consumers had no savings cushion
• Business vulnerability mirrored consumer fragility—companies also relied heavily on credit, making the entire economy a house of cards

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Banking System Collapse

The banking crisis transformed a stock market crash into a full economic catastrophe. Without deposit insurance or effective federal intervention, bank failures created a self-reinforcing cycle of panic and contraction.

Bank Failures

• Over 9,000 banks failed between 1930 and 1933, destroying the savings of millions of Americans who had no federal protection
• Money supply contracted by roughly one-third as failed banks removed currency from circulation, creating severe deflation
• Loss of trust triggered bank runs even at healthy institutions—fear itself became an economic force, as depositors rushed to withdraw funds before their bank collapsed

Contractionary Monetary Policy

• Federal Reserve raised interest rates in the late 1920s to cool speculation, but this restricted credit precisely when businesses needed liquidity
• Tight money policy continued even as the Depression deepened, reflecting the Fed's misunderstanding of its role as lender of last resort
• Deflation accelerated as reduced money supply made debts harder to repay in real terms, crushing farmers and businesses with fixed obligations

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Structural Economic Weaknesses

The Depression revealed that 1920s prosperity was unevenly distributed and fundamentally unstable. An economy where most people lack purchasing power cannot sustain growth, no matter how productive its industries become.

Uneven Distribution of Wealth

• Top 1% held over 40% of the nation's wealth by 1929, while the bottom 40% had virtually no savings
• Limited consumer purchasing power meant that mass production outpaced the ability of ordinary Americans to buy goods
• Structural instability resulted from an economy dependent on luxury spending and investment by the wealthy, both of which collapsed during uncertainty

Agricultural Overproduction and Falling Crop Prices

• Mechanization increased yields dramatically, but demand remained flat, causing commodity prices to fall throughout the 1920s—farmers experienced depression before the crash
• Crushing debt burdens forced farmers to produce even more to meet payments, which further depressed prices in a vicious cycle
• Rural poverty preceded and outlasted urban unemployment, making agriculture a persistent drag on national recovery

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Demand Collapse and Unemployment Spiral

Once the initial shocks hit, the economy entered a self-reinforcing downward spiral. Reduced spending led to layoffs, which reduced spending further—a feedback loop that policy failures only intensified.

Reduction in Consumer Spending

• Confidence collapse caused even employed Americans to cut back, hoarding cash against uncertain futures
• Inventory buildup forced businesses to slash production and lay off workers, spreading the crisis from finance to manufacturing
• Multiplier effect in reverse—each dollar of reduced spending rippled through the economy, causing several dollars of lost economic activity

High Unemployment Rates

• 25% unemployment at the Depression's peak meant one in four workers had no income, devastating families and communities
• Underemployment was even more widespread, with millions working reduced hours or accepting drastic pay cuts
• Human capital destruction occurred as prolonged joblessness eroded skills and created a generation marked by economic trauma

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Policy Failures and External Shocks

Government responses often worsened the crisis, while environmental disaster compounded economic suffering. The Depression demonstrated that laissez-faire approaches were inadequate for systemic economic collapse.

Protectionist Trade Policies (Smoot-Hawley Tariff)

• Smoot-Hawley Tariff of 1930 raised duties on over 20,000 imported goods to record levels, attempting to protect American industry
• Retaliatory tariffs from trading partners collapsed international trade by roughly 65% between 1929 and 1934
• Global depression deepened as nations pursued beggar-thy-neighbor policies, demonstrating the dangers of economic nationalism

Drought and Dust Bowl Conditions

• Severe drought beginning in 1930 devastated the Great Plains, turning overfarmed soil into dust
• "Okies" and mass migration—hundreds of thousands of displaced farming families fled to California and other states, overwhelming local resources
• Environmental and economic crisis merged, as agricultural collapse intensified rural poverty and strained New Deal relief efforts

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Quick Reference Table

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Self-Check Questions

1. Which two causes of the Great Depression both reflect the problem of excessive leverage, and how did they interact to deepen the crisis?

2. Explain how Federal Reserve policy and bank failures both contributed to money supply contraction—what was the key difference between these two factors?

3. Compare the economic problems facing farmers with those facing urban industrial workers. What underlying issue connected both groups' struggles?

4. If an FRQ asked you to explain why the Depression lasted so long, which three causes would you emphasize as creating self-reinforcing cycles? Justify your choices.

5. How did the Smoot-Hawley Tariff demonstrate the dangers of nationalist economic policy during a global crisis? What lesson does this hold for understanding international economic cooperation?