The Great Depression 1929-1933

The great financial crisis faced by the United States was during the great depression from 1929-1933. How adverse selection and moral hazards are held responsible for this depression?

• OVERVIEW:

Worldwide economic downturn begun in 1929, and lasted until 1933. It was the longest and most severe depression ever experienced by the industrialized Western world. Although the depression originated in the United States but that resulted in acute worldwide depression.

The timing and severity of the Great Depression varied substantially across countries. The Depression was particularly long and severe in the United States and Europe; it was milder in Japan and much of Latin America. Perhaps not surprisingly, the worst depression ever experienced stemmed from a multitude of causes. In the United States, the Great Depression began in 1929. The downturn became markedly worse in late 1929 and continued until early 1933. Real output and prices fell suddenly. Industrial production in the United States declined 47 percent and real GDP fell by 30%.

• CAUSES OF GREAT DEPRESSION:

The depression from 1929-1933 is mainly caused by adverse selections and moral hazards. The effects of adverse selection and moral hazard are caused by asymmetric information and it can help us understand financial crises.

When certain factor(s) hit the financial markets during that time, adverse selection and moral hazard problems worsen the financial crisis. As there were many factors or forces that caused financial crisis in US. Let’s examine few of them in detail (and How the financial crisis (1929-1933) get worse?):

FLUCTUATIONS IN STOCK PRICES:

• The fundamental cause of the Great Depression in the United States was a decline in Spending sometimes referred to as aggregate demand and variety of other factors also influenced the downturn in various countries. Stock market crash also contributed towards the depression and was from one of the factors. Decrease in stock prices of the firms resulted in drastic decrease in net worth of the firms. When net worth of most of the firms went down, firms tried to raise their capital and in order to do this, they issued more shares, and consequently, by doing this, they were involved in adverse selection as the firms were increasing the related loss of the lenders, in case of default. On the other hand, lower net worth of the firms also involved moral hazards that contributed towards more disastrous financial crisis. Lower net worth (collateral value) worsen the problem because when the firms had nothing to lose then they tried to shift their sources of incomes towards the more riskier investment and by doing this firms started to lose more and more money and ultimately, this resulted in insolvency of many of the firms. As a result, variety of minor events led to gradual price declines, investors lost confidence and the stock market bubble burst .The stock market crash reduced American aggregate demand substantially. And subsequently, the struggle of US economy along with other western economies started.

BANKING PANICS:

• The next blow to aggregate demand occurred in 1930, when the first of four waves of banking panics gripped the United States. A banking panic arose when many depositors lost confidence in the solvency of banks and simultaneously demanded their deposits. Deterioration in bank balance sheets started to begin and fear led to bank panics. Banks, which typically hold only a fraction of deposits as cash reserves, had to liquidate loans in order to raise the required cash and unfortunately, investors had no confidence in banks and were unwilling to invest their money with banks. The decline in bank lending reduced the supply of funds and raised interest rates, and the problems of adverse selection and moral hazard arose which aggravated the financial crisis. When Interest rates increased significantly good borrowers were driven out of the market and the problem of adverse selection worsen the financial crisis. As interest was high, at that time only bad borrowers were interested in borrowing at higher interest but default risk of those entities was higher and ultimately most of the borrowers defaulted. Hence, The United States experienced widespread banking panics in the fall of 1930, the spring of 1931, the fall of 1931, and the fall of 1932.

• The final wave of panics continued through the winter of 1933. One way to restore confidence of the public when it comes to generate some deposits was to sort out good banks from bad banks either by: the government or central bank, a private-clearing house (an example is the clearing house organized by J.P. Morgan in1893 and 1907 panic. The clearing house acted as the central bank and selectively issue certificates to provide liquidity for the banking system). In order to gain public confidence, banks were permitted to run only after being deemed solvent by government inspectors. This means that banks were only allowed to operate on the basis of sovereign guarantee by the state itself. Knowing the fact that state has given a sovereign guarantee, this also somehow or the other created the scenario of adverse selections and moral hazards, and contributed towards the financial crisis. This made it harder for banks to sort out good borrowers from bad borrowers as they knew that state is behind all the deposits acting as an insurance company, therefore banks again started to get involved in adverse selections while the selection of borrowers and in moral hazards while lending too much of the deposits and created the environment of uncertainty by using the deposits in an ineffective manner and didn’t involve themselves in any kind of risk management and whenever, there is lesser risk management; those kind of events are more likely to occur. For better understanding of what happened with the banking system in US during the financial crisis, let’s take more simpler example and relate it to the financial crisis, keeping in view the current scenario of PIA no one is willing and able to advance funds to this institution other than government, but whenever this institution goes to get funded, every lender ask for sovereign guarantee that is issued by state. And in case if  government issues guarantee then there will be more moral hazards, as PIA would know that it is backed by government and major adverse selection for bank would arise, when knowing that state has also defaulted and you still advance funds. Many of the events of the same magnitude affected by adverse selections and moral hazards arose during the financial crisis (1929-1933) in US and proved to be disastrous for the economy.
• The panics took a severe toll on the American banking system. By 1933, one-fifth of the banks in existence at the start of 1930 had failed. By their nature, banking panics are largely irrational, inexplicable events, but some of the factors contributing to the problem can be explained. Economic historians believe that substantial increases in debt and either too much adverse selections when it came to lending money or too much moral hazards when it came to using deposits, together with U.S. policies where adverse selections were made while selecting policies that encouraged banks to advance more loans and created an environment which involved more risk.

OTHER FACTORS CONTRIBUTING TOWARDS THE GREAT FINANCIAL CRISIS:

• During this whole period from 1929-1933 most of the borrowings were made by bad borrowers which included mostly farmers. The heavy debt stemmed in part from the response to the high prices of agricultural goods. Americans borrowed heavily to purchase in order to increase production. The decline in farm commodity prices made it difficult for farmers to keep up with their loan payments. The Federal Reserve did little to try to restrict the banking panics. The panics caused a dramatic rise in the amount of currency people wished to hold relative to their bank deposits. In the early 1930s, decline in the money supply depressed spending in a number of ways. Perhaps most importantly, because of actual price declined and the rapid decline in the money supply, consumers and business people came to expect deflation – that is, they expected wages and prices to be lower in the future. As a result, even though nominal interest rates were very low, people did not want to borrow because; as they feared that future wages and profits would be inadequate to cover the loan payments. This hesitancy, in turn, led to severe reductions in both consumer spending and business investment spending. The panics surely exacerbated the decline in spending by generating negativity and a loss of confidence. Furthermore, the failure of so many banks disrupted lending .These widespread banking crises could have also been the result of poor regulation.