Asymmetric Information

Adverse Selection & Moral Hazard

In The Great Depression

Introduction

The Great Depression was a severe worldwide economic depression in the decade preceding World War II. It was the longest, most widespread, and deepest depression of the 20th century. The Great Depression had devastating effects in virtually every country, rich and poor. Personal income, tax revenue, profits and prices dropped, while international trade plunged by more than 50%. Unemployment in the U.S. rose to 25%, and in some countries rose as high as 33%. Cities all around the world were hit hard, especially those dependent on heavy industry. Construction was virtually halted in many countries. Farming and rural areas suffered as crop prices fell by approximately 60%. Facing plummeting demand with few alternate sources of jobs, areas dependent on primary sector industries such as cash cropping, mining and logging suffered the most.

There were multiple causes for the first downturn in 1929. These include the structural weaknesses and specific events that turned it into a major depression and the manner in which the downturn spread from country to country. In relation to the 1929 downturn, historians emphasize structural factors like major bank failures and actions by the US Federal Reserve that contracted the money supply, as well as Britain's decision to return to the Gold Standard at pre-World War I parities.

Main Body

In this report, we mainly consider how adverse selection and moral hazard, which are examples of asymmetric information, contributed to the Great Depression. According to our research, from the financial view, there are two major factors caused the Great Depression.

1. The Stock Market Crash

The one of the most important factors that caused the Great Depression is the stock market crash, which started from October 24, 1929, also called \"Black Thursday\". On Black Thursday, the market lost 11% of its value at the opening bell on very heavy trading. On October 28, more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 38 points, or 13%. The next day, about 16 million shares were traded, and the Dow lost an additional 30 points, or 12%. The volume of stocks traded on October 29 was a record that was not broken for nearly 40 years.

Table 1 Dow Jones Industrial Average Date October 28, 1929 October 29, 1929 Change -38.33 -30.57 % Change -12.82 -11.73 Close 260.64 230.07 According to our study, in adverse selection view, we find that the stock market crash led to investment reduction and economic activity level reduction. Because stock price reflects a company's net value, stock market crash results in net value reduction and margin buying price reduction. Since the margin buying value

decreases, the protection will decline, lenders will cut down the number of credit. Therefore, the stock market crash means that lenders will not to provide credit to the company, the number of credit and the investment level decrease, and then the economic activity level declines, the total economic output fails.

In moral hazard view, the stock market crash signifies a company's net value crash, which stimulates company to work on high yield, high risk investment. That's because high risk accompanies high yield, and the net value crash encourage company's

adventure motivation, which increases the moral hazard. As a result, lenders have no enthusiasm to make loans,and then the economic activity level declines, the total economic output fails.

In the late 1920s, hundreds of thousands of Americans invested heavily in the stock market. A significant number of them were borrowing money to buy more stocks. By August 1929, brokers were routinely lending small investors more than two-thirds of the face value of the stocks they were buying. Over $8.5 billion was out of loan, more than the entire amount of currency circulating in the U.S. at the time. Because of margin buying, investors stood to lose large sums of money if the market crash. On October 24, 1929, with the Dow just past its September 3 peak of 381.17, the market finally turned down, and panic selling started, and aggravated the depression. 2.Bank Panics

Bank plays a very important role while putting capital from nonproductive use to productive use, bank is the most important source of industrial and commercial enterprises' external financing. But if bank panics happen, as known as numerous banks close down, financial intermediary activities through banks deplete, which make the most important exogenous capital supply of industrial and commercial enterprises decrease much, consequently, interest rate rises and loan decreases.

Moreover, if interest rate rises, those people who are willing to make loan are mostly full of adventure, which make adverse selection even worse. While bank panics and rise of interest rate happen at the same time, adverse selection is getting worse and the size of the loan become less and less. Therefore, bank panics make investment decline badly, and then economics activity level drops.

During the crash of 1929 preceding the Great Depression, margin requirements were only 10%. When the market fell, brokers called in these loans, which could not be paid back. Banks began to fail as debtors defaulted on debt and depositors

attempted to withdraw their deposits, triggering multiple bank runs. Bank failures led to the loss of billions of dollars in assets.Outstanding debts became heavier, because prices and incomes fell by 20–50% but the debts remained at the same dollar amount. After the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. By April 1933, around $7 billion in deposits had been frozen in failed banks or those left unlicensed after the March Bank Holiday. Bank failures snowballed as desperate bankers called in loans, which the borrowers did not have time or money to repay. With future profits looking poor, capital investment and construction slowed or completely ceased. In the face of bad loans and worsening future prospects, the

surviving banks became even more conservative in their lending. Banks built up their capital reserves and made fewer loans, which intensified deflationary pressures. A

vicious cycle developed and the downward spiral accelerated.

Conclusion

After our research, our group admits that adverse selection and moral hazard do have great contribution to the Great Depression, not only in the stock market crash, but also bank panics. They both satisfy economic activity's law. When we study economic depression on every decade, adverse selection and moral hazard should not be ignored, they help us learn more from depression.

Reference

1.http://en.wikipedia.org/wiki/Asymmetric_information 2.http://en.wikipedia.org/wiki/Adverse_selection 3.http://en.wikipedia.org/wiki/Moral_hazard 4.http://www.amatecon.com/gd/gdoverview.html 5.http://www.amatecon.com/gd/gdcandc.html

6.Money And Banking Course, Kangping Wu, Tsinghua University Press