Financial Markets and Institutions (2-downloads)

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 vir-

tually no credit risk, as shown in Figure 8.3. With so many fewer banks still in busi-

ness, 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

0.0%

4.0%

2.0%

6.0%

8.0%

10.0%

1929

1930

1931

1932

1933

1934

1935

1936

1937

1938

1939

Baa-U.S. Treasury

Spread (%)

F I G U R E   8 . 3

Credit Spreads During the Great Depression

Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose

sharply during the Great Depression.

Source: Federal Reserve Bank of St. Louis FRED database, 

http://research.stlouisfed.org/fred2/categories/22

.

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?