THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 235

CHAPTER 9

Financial Crises and the Subprime Meltdown 203

Stage Two:
Banking
Crisis

Because of the worsening business conditions and uncertainty about their banks
health, depositors begin to withdraw their funds from banks and a banking crisis
or bank panic often ensues. The resulting decline in the number of banks results
in a loss of their information capital and worsening adverse selection and moral
hazard problems in the credit markets, leading to a further spiralling down of the
economy. Figure 9-1 illustrates this progression in the Stage Two portion. Bank
panics were a feature of all Canadian financial crises during the nineteenth and
twentieth centuries, occurring in 1866, 1879, 1923, and 1930 1933. Bank panics
were also a feature of all U.S. financial crises until World War II, occurring every
twenty years or so in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930 33.
For the typical Canadian financial crisis, there is then a sorting out of firms that
were insolvent (had a negative net worth) from healthy firms by bankruptcy proceedings. The same process occurs for banks, often with the help of public and
private authorities. Once this sorting out is complete, uncertainty in financial markets declines, the stock market recovers, and interest rates fall. The overall result
is that adverse selection and moral hazard problems diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set
for the recovery of the economy, bringing us to the next possible stage.

Stage Three:
Debt
Deflation

If, however, the economic downturn leads to a sharp decline in prices, the recovery
process can be short-circuited. In this situation, shown as Stage Three in Figure 9-1,
a process called debt deflation occurs, in which a substantial unanticipated

decline in the price level sets in, leading to further deterioration in firms net worth
because of the increased burden of indebtedness. With debt deflation, the adverse
selection and moral hazard problems continue to increase so that lending, investment spending, and aggregate economic activity remain depressed for a long time.
The most significant financial crisis that included debt deflation was the Great
Depression, the worst economic contraction in history.

AP PL ICAT I ON

The Mother of All Financial Crises:
The Great Depression in the United States
In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom 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, falling by more
than 60%.
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. Indeed, credit market conditions remained quite
stable and there was little evidence that a major financial crisis was underway.
What might have been a normal recession turned into something far different,
however, when adverse shocks to the agricultural sector led to bank failures in
agricultural regions that then spread to the major banking centres. A sequence of
bank panics followed from October 1930 until March 1933. More than one-third of
U.S. banks 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