The Great Depression

The Great Depression

Federal Reserve officials viewed the stock market boom of 1928 and 1929, during which stock prices doubled, 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.

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. What might have been a normal recession turned into something far

different, however, with adverse shocks to the agricultural sector, a continuing decline in the stock market after the middle of 1930, and a sequence of bank collapses from October 1930 until March 1933 in which over one-third of the banks in the United States went out of business.

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 made adverse selection and moral hazard problems worse in the credit markets. The loss of one-third of the banks reduced the amount of financial intermediation. This intensified adverse selection and moral hazard problems, thereby decreasing the ability of financial markets to channel funds to firms with productive investment opportunities. As our analysis predicts, the amount of outstanding commercial loans fell by half from 1929 to 1933, and investment spending collapsed, declining by 90% from its 1929 level.

The short-circuiting of the process that kept the economy from recovering quickly, which it does in most recessions, occurred because of a fall in the price level by 25% in the 1930–1933 period. This huge decline in prices triggered a debt deflation in which net worth fell because of the increased burden of indebtedness