The Great Depression had two primary causes: an excessively tight monetary policy caused NGDP to drop in half between 1929 and early 1933, and then a set of New Deal policies such as the National Industrial Recovery Act (NIRA) slowed what would have been an extremely fast recovery after the dollar was devalued in 1933.
I've already talked about how reasoning from a price change contributed to the tight money policy of 1929-33. Most pundits and policymakers looked at the rapidly falling level of nominal interest rates and assumed that money was easy. In fact, rates were falling because of a decline in demand for credit, caused by the Depression itself. Money was actually very tight.
While cleaning up my office, I noticed an old NYT story that points to another type of reasoning from a price change:
You might think this is simply another example of foolish Italian public policy, which doesn't apply to the US. In fact, this sort of policy provided one inspiration for FDR's New Deal, and specifically the NIRA. Roosevelt believed that falling prices were the cause of the Great Depression, and set up the NIRA (and AAA) to restrict production and raise output.
I'm sure most of my readers see the problem here. Only deflation caused by falling demand could be said to have caused the Depression. A policy of boosting demand would raise both prices and output, thus contributing to recovery. However, a decrease in supply would raise prices by reducing output, making the Depression even worse.
This is not just a right wing critique of the New Deal; Keynes discussed the same problem in an open letter to FDR, published in the NYT back in December 1933:
That is my first reflection--that N.I.R.A., which is essentially Reform and probably impedes Recovery, has been put across too hastily, in the false guise of being part of the technique of Recovery. . . .
I do not mean to impugn the social justice and social expediency of the redistribution of incomes aimed at by N.I.R.A. and by the various schemes for agricultural restriction. The latter, in particular, I should strongly support in principle. But too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round.
Keynes sees FDR putting the cart before the horse, trying to artificially raise prices, not have them rise as a consequence of recovery promoted by boosting demand.
[Notice that Keynes refers to "aggregate purchasing power" which is essentially NGDP. Elsewhere I've argued that much of the General Theory is quite "market monetarist", with his focus on the relationship between nominal hourly wages and NGDP being quite similar to my "musical chairs model."]
The tight money policy of 1929 was adopted to slow the stock market boom. I suppose that's also a sort of reasoning from a price change, failing to distinguish between asset price rises caused by an overheated economy, and those reflecting good fundamentals. But I'd argue that this policy error is better described as reflecting a rejection of the efficient market hypothesis. Either way, when policymakers ignore the basic principles of economics, bad things tend to happen.
BTW, reasoning from a price change also caused the Great Recession. In addition to the well-known interest rate fallacy, the Fed and ECB were fooled by rising inflation in 2008, wrongly viewing that as evidence that monetary policy was too easy. The Fed passively tightened while the ECB actually raised rates in July 2008. In fact, the higher inflation was caused by a reduction in AS, not a rise in AD.
PS. It's interesting how often the US adopts fads that started in Italy. When Italy elected Silvio Berlusconi in the late 1990s, I shook my head in disbelief. At the time, I couldn't imagine American voters doing anything remotely similar.
PPS. Some people argue that the New Deal had "fascist" roots, pointing to inspiration provided by Mussolini. There's a bit of truth in that claim, but it's also a bit unfair---given that in the modern world the term 'fascism' is associated with highly repressive and racist policies adopted in places like Germany. The meaning of words evolves over time, and that accusation had more merit in 1933 than today.
PPPS, Keynes' entire 1933 letter is quite interesting and worth reading. For instance, it makes clear that Keynes' belief in liquidity traps was not a "myth".