THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 236

204

PA R T I I I

Financial Institutions

from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in the credit markets. The loss
of one-third of the banks reduced the amount of financial intermediation.
Intensified adverse selection and moral hazard problems decreased 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 debt
deflation in which net worth fell because of the increased burden of indebtedness
borne by firms. The decline in net worth and the resulting increase in adverse
selection and moral hazard problems in the credit markets led to a prolonged economic contraction in which unemployment rose to 25% of the labour force. The
financial crisis in the Great Depression was the worst ever experienced, and it
explains why this economic contraction was also the most severe ever experienced by the United States.1

THE SUBP RI ME FI N ANC IAL CRISI S O F 20 0 7 2 0 08
Now that our framework for analyzing financial crises is in place, we are prepared
to tackle the most recent financial crisis, the subprime financial crisis of 2007 2008
in the United States. Mismanagement of financial innovation in the subprime residential mortgage market and the bursting of a bubble in housing prices were the
underlying driving forces behind the U.S. financial crisis of 2007 2008.

Financial
Innovations
Emerge in the
Mortgage

Markets

Before 2000, only the most credit-worthy (prime) borrowers were able to obtain
residential mortgages. Advances in computer technology and new statistical techniques, known as data mining, however, led to enhanced, quantitative evaluation
of the credit risk for a new class of riskier residential mortgages. Subprime mortgages are mortgages for borrowers with less-than-stellar credit records. Alt-A
mortgages are mortgages for borrowers with higher expected default rates than
prime (A-paper), but with better credit records than subprime borrowers.
Households with credit records could now be assigned a numerical credit score,
known in the United States as a FICO score (named after the Fair Isaac Corporation
that developed it), that would predict how likely they would be to default on their
loan payments. In addition, by lowering transaction costs, computer technology
enabled the bundling together of smaller loans (like mortgages) into standard debt
securities, a process known as securitization.

1

For a discussion of the role of asymmetric information problems in the Great Depression period, see
Ben Bernanke, Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression, American Economic Review 73 (1983): 257 276; and Charles Calomiris, Financial Factors
and the Great Depression, Journal of Economic Perspectives (Spring 1993): 61 85.