Financial Markets and Institutions (2-downloads)

169

C A S E

The Mother of All Financial Crises: 

The Great Depression

In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve offi-

cials viewed the stock market boom as excessive speculation. To curb it, they pur-

sued 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 genera-

tion, 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, how-

ever, when adverse shocks to the agricultural sector led to bank failures in agricul-

tural regions that then spread to the major banking centers. A sequence of bank panics

0.0

20.0

10.0

30.0

40.0

50.0

1929

1930

1931

1932

1933

1934

1935

1936

1937

1938

1939

60.0

80.0

70.0

90.0

100.0

Stock Prices

(Dow-Jones Industrial Average,

September 1929 = 100)

F I G U R E   8 . 2

Stock Price Data During the Great Depression Period

Stock prices crashed in 1929, falling by more than 60%, and then continued to fall to only 10% of their peak

value by 1932.

Source: Dow-Jones Industrial Average (DJIA), 

http://lib.stat.cmu.edu/datasets/djdc0093

.

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170

Part 3 Fundamentals of Financial Institutions

1

For a discussion of the role of asymmetric information problems in the Great Depression period, see

Ben Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great

Depression,” American Economic Review 73 (1983): 257–276, and Charles Calomiris, “Financial

Factors and the Great Depression,” Journal of Economic Perspectives (Spring 1993): 61–85.

followed from October 1930 until March 1933. As shown in Figure 8.2, the continu-

ing 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 busi-

ness 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