The greatest financial crisis faced by the United States was the Great Depression, from 1929 to

1933. Write a one-page summary explaining how adverse selection and moral hazard
contributed to the Great Depression.

CASE STUDY OF FINANCIAL CRISIS: THE GREAT DEPRESSION

The Great Depression (1929-39) was the deepest and longest-lasting economic
downturn in the history of the Western industrialized world. In the United States, the
Great Depression began soon after the stock market crash of October 1929, which
sent Wall Street into a panic and wiped out millions of investors. Over the next
several years, consumer spending and investment dropped, causing steep declines
in industrial output and rising levels of unemployment as failing companies laid off
workers. By 1933, when the Great Depression reached its nadir, some 13 to 15
million Americans were unemployed and nearly half of the country’s banks had
failed. Though the relief and reform measures put into place by President Franklin
D. Roosevelt helped lessen the worst effects of the Great Depression in the 1930s,
the economy would not fully turn around until after 1939, when World War II kicked
American industry into high gear.

The Great Depression Begins: The Stock Market Crash of 1929

The American economy entered an ordinary recession during the summer of 1929,
as consumer spending dropped and unsold goods began to pile up, slowing
production. At the same time, stock prices continued to rise, and by the fall of that
year had reached levels that could not be justified by anticipated future earnings. On
October 24, 1929, the stock market bubble finally burst, as investors began dumping
shares en masse. A record 12.9 million shares were traded that day, known as “Black
Thursday.” Five days later, on “Black Tuesday” some 16 million shares were traded
after another wave of panic swept Wall Street. Millions of shares ended up worthless,
and those investors who had bought stocks “on margin” (with borrowed money) were
wiped out completely.

As consumer confidence vanished in the wake of the stock market crash, the
downturn in spending and investment led factories and other businesses to slow
down production and construction and begin firing their workers. For those who were
lucky enough to remain employed, wages fell and buying power decreased. Many
Americans forced to buy on credit fell into debt, and the number of foreclosures and
repossessions climbed steadily. The adherence to the gold standard, which joined
countries around the world in a fixed currency exchange, helped spread the
Depression from the United States throughout the world, especially in Europe.
The Great Depression Deepens: Bank Runs and the Hoover Administration

Despite assurances from President Herbert Hoover and other leaders that the crisis
would run its course, matters continued to get worse over the next three years. By
1930, 4 million Americans looking for work could not find it; that number had risen to
6 million in 1931. Meanwhile, the country’s industrial production had dropped by half.
Bread lines, soup kitchens and rising numbers of homeless people became more
and more common in America’s towns and cities. Farmers (who had been struggling
with their own economic depression for much of the 1920s due to drought and falling
food prices) couldn’t afford to harvest their crops, and were forced to leave them
rotting in the fields while people elsewhere starved.

In the fall of 1930, the first of four waves of banking panics began, as large numbers
of investors lost confidence in the solvency of their banks and demanded deposits
in cash, forcing banks to liquidate loans in order to supplement their insufficient cash
reserves on hand. Bank runs swept the United States again in the spring and fall of
1931 and the fall of 1932, and by early 1933 thousands of banks had closed their
doors. In the face of this dire situation, Hoover’s administration tried supporting
failing banks and other institutions with government loans; the idea was that the
banks in turn would loan to businesses, which would be able to hire back their
employees.

What caused the Great Depression? To get a handle on that, it's necessary to look
at previous depressions and compare. The Great Depression was by no means the
first depression this country ever had, but it was clearly the worst. What made it
different than the rest? At the time of the Great Depression, government intervention
in the economy was higher than it had ever been and a special government agency
had been set up specifically to prevent depressions and their associated problems,
such as bank panics. This agency was the Federal Reserve Board and it was to
have been the loaner of last resorts for banks in order to prevent collapses as had
happened during earlier depressions. But as we'll see, there is good reason to
believe that the Fed's actions explain a lot of the problems that lead up to the Stock
market crash and the subsequent depression.

So what went wrong? It was in 1929 that the Fed realized that it could not sustain
its current policy. When it started to raise interest rates, the whole house of cards
collapsed. The Stock Market crashed and the bank panics began. But what would
make this depression worse than all the rest? There was a depression in 1921, but
no one remembers that one. What was different? As we'll see, there were a number
of policies enacted over the next few years that, from both a free market and a
Keynesian perspective, would do nothing to help America recover and do everything
to exacerbate the depression. Over the next few years, the Fed would allow the
money supply to contract by a third.

The Great Depression was an economic slump in North America, Europe, and other
industrialized areas of the world that began in 1929 and lasted until about 1939. It
was the longest and most severe depression ever experienced by the industrialized
Western world.

Though the U.S. economy had gone into depression six months earlier, the Great
Depression may be said to have begun with a catastrophic collapse of stock-market
prices on the New York Stock Exchange in October 1929. During the next three
years stock prices in the United States continued to fall, until by late 1932 they had
dropped to only about 20 percent of their value in 1929. Besides ruining many
thousands of individual investors, this precipitous decline in the value of assets
greatly strained banks and other financial institutions, particularly those holding
stocks in their portfolios. Many banks were consequently forced into insolvency; by
1933, 11,000 of the United States' 25,000 banks had failed. The failure of so many
banks, combined with a general and nationwide loss of confidence in the economy,
led to much-reduced levels of spending and demand and hence of production, thus
aggravating the downward spiral. The result was drastically falling output and
drastically rising unemployment; by 1932, U.S. manufacturing output had fallen to
54 percent of its 1929 level, and unemployment had risen to between 12 and 15
million workers, or 25-30 percent of the work force.

The Great Depression began in the United States but quickly turned into a worldwide
economic slump owing to the special and intimate relationships that had been forged
between the United States and European economies after World War I. The United
States had emerged from the war as the major creditor and financier of postwar
Europe, whose national economies had been greatly weakened by the war itself, by
war debts, and, in the case of Germany and other defeated nations, by the need to
pay war reparations. So once the American economy slumped and the flow of
American investment credits to Europe dried up, prosperity tended to collapse there
as well. The Depression hit hardest those nations that were most deeply indebted to
the United States, i.e., Germany and Great Britain. In Germany, unemployment rose
sharply beginning in late 1929, and by early 1932 it had reached 6 million workers,
or 25 percent of the work force. Britain was less severely affected, but its industrial
and export sectors remained seriously depressed until World War II. Many other
countries had been affected by the slump by 1931.

Almost all nations sought to protect their domestic production by imposing tariffs,
raising existing ones, and setting quotas on foreign imports. The effect of these
restrictive measures was to greatly reduce the volume of international trade: by 1932
the total value of world trade had fallen by more than half as country after country
took measures against the importation of foreign goods.
The Great Depression had important consequences in the political sphere. In the
United States, economic distress led to the election of the Democrat Franklin D.
Roosevelt to the presidency in late 1932. Roosevelt introduced a number of major
changes in the structure of the American economy, using increased government
regulation and massive public-works projects to promote a recovery. But despite this
active intervention, mass unemployment and economic stagnation continued,
though on a somewhat reduced scale, with about 15 percent of the work force still
unemployed in 1939 at the outbreak of World War II. After that, unemployment
dropped rapidly as American factories were flooded with orders from overseas for
armaments and munitions. The depression ended completely soon after the United
States' entry into World War II in 1941. In Europe, the Great Depression
strengthened extremist forces and lowered the prestige of liberal democracy. In
Germany, economic distress directly contributed to Adolf Hitler's rise to power in
1933. The Nazis' public-works projects and their rapid expansion of munitions
production ended the Depression there by 1936.

At least in part, the Great Depression was caused by underlying weaknesses and
imbalances within the U.S. economy that had been obscured by the boom
psychology and speculative euphoria of the 1920s. The Depression exposed those
weaknesses, as it did the inability of the nation's political and financial institutions to
cope with the vicious downward economic cycle that had set in by 1930. Prior to the
Great Depression, governments traditionally took little or no action in times of
business downturn, relying instead on impersonal market forces to achieve the
necessary economic correction. But market forces alone proved unable to achieve
the desired recovery in the early years of the Great Depression, and this painful
discovery eventually inspired some fundamental changes in the United States'
economic structure. After the Great Depression, government action, whether in the
form of taxation, industrial regulation, public works, social insurance, social-welfare
services, or deficit spending, came to assume a principal role in ensuring economic
stability in most industrial nations with market economies.

In October 1929 the stock market crashed, wiping out 40 percent of the paper values
of common stock. Even after the stock market collapse, however, politicians and
industry leaders continued to issue optimistic predictions for the nation's economy.
But the Depression deepened, confidence evaporated and many lost their life
savings. By 1933 the value of stock on the New York Stock Exchange was less than
a fifth of what it had been at its peak in 1929. Business houses closed their doors,
factories shut down and banks failed. Farm income fell some 50 percent. By 1932
approximately one out of every four Americans was unemployed.

The core of the problem was the immense disparity between the country's productive
capacity and the ability of people to consume. Great innovations in productive
techniques during and after the war raised the output of industry beyond the
purchasing capacity of U.S. farmers and wage earners. The savings of the wealthy
and middle class, increasing far beyond the possibilities of sound investment, had
been drawn into frantic speculation in stocks or real estate. The stock market
collapse, therefore, had been merely the first of several detonations in which a flimsy
structure of speculation had been leveled to the ground.

By 1933 millions of Americans were out of work. Bread lines were a common sight
in most cities. Hundreds of thousands roamed the country in search of food, work
and shelter. "Brother, can you spare a dime?" went the refrain of a popular song.

An early step for the unemployed came in the form of the Civilian Conservation Corps
(CCC), a program enacted by Congress to bring relief to young men between 18 and
25 years of age. Run in semi-military style, the CCC enrolled jobless young men in
work camps across the country for about $30 per month. About 2 million young men
took part during the decade. They participated in a variety of conservation projects:
planting trees to combat soil erosion and maintain national forests; eliminating
stream pollution; creating fish, game and bird sanctuaries; and conserving coal,
petroleum, shale, gas, sodium and helium deposits.

Work relief came in the form of the Civil Works Administration. Although criticized as
"make work," the jobs funded ranged from ditch digging to highway repairs to
teaching. Created in November 1933, it was abandoned in the spring of 1934.
Roosevelt and his key officials, however, continued to favor unemployment
programs based on work relief rather than welfare.