The Mother of All Financial Crises:
The Great Depression In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation. To curb it, they pursued a tight monetary policy to raise interest rates; the Fed got more than it bargained for when the stock market crashed in October 1929, falling by 20% (Figure 8.2). Although the 1929 crash had a great impact on the minds of a whole generation, most people forget that by the middle of 1930, more than half of the stock market decline had been reversed. Indeed, credit market conditions remained quite stable and there was little evidence that a major financial crisis was underway. What might have been a normal recession turned into something far different, however, when adverse shocks to the agricultural sector led to bank failures in agricultural regions that then spread to the major banking centers. A sequence of bank panics followed from October 1930 until March 1933. As shown in Figure 8.2, the continuing decline in stock prices after mid 1930 (by mid 1932 stocks had declined to 10% of their value at the 1929 peak) and the increase in uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in the credit markets. The loss of one third of the banks reduced the amount of financial intermediation. Lenders began charging businesses much higher interest rates to protect themselves from credit losses. Risk premiums (also called credit spreads) widened, with interest rates on corporate bonds with a Baa (medium quality) credit rating rising relative to similar maturity Treasury bonds, which have virtually no credit risk, as shown in Figure 8.3. With so many fewer banks still in business, adverse selection and moral hazard problems intensified. Financial markets struggled to channel funds to firms with productive investment opportunities. The ongoing deflation that started in 1930 eventually led to a 25% decline in the price level. This deflation short circuited the normal recovery process that occurs in most recessions. This huge decline in prices triggered a debt deflation in which net worth fell because of the increased burden of indebtedness borne by firms. The decline in net worth and the resulting increase in adverse selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unemployment rose to 25% of the labor force. The financial crisis in the Great Depression was the worst ever experienced in the United States, and it explains why this economic contraction was also the most severe ever experienced by the nation.1