Finance

Adverse selection and moral hazard problems are well known to cause financial crises. Adverse selection specifically hampers the running of financial markets as bad credit risks motivate loan borrowing. Moral hazard is a principal-agent problem whereby managers as the agents get less profit maximizing incentives compared to the stockholders who are the principals.  As such, borrowers indulge in economic activities that are less desirable as far as the lender is concerned. An increase in adverse selection and moral hazard problems can therefore be termed as among the primary causes of the Great Depression of the 1930s.

Adverse selection and moral hazard in the Great Depression
The 1920s were characterized by a thriving economy which made the stock prices to keep rising. This attracted investors and banks as it was seen as an easy way of making millions of money. Investors never seemed to understand the principles and trends in stock markets and instead they wanted to enter the market through all means possible. It is for this reason that increased their borrowing all in an attempt to gain investment in the sure stock market. With increasing hopes that the stock market would have great returns, the stock prices doubled through 1928 and the great part of 1929. Little was it known that the economy was built on an inverted pyramid as stock market crush occurred in the last quarter of 1929. At this point, the economy was already having adverse selection problems as people would borrow to invest in a market that was thought to be stable only to prove unstable by the crush. The stock market crush is well known to have exacerbated the Great Depression.

Banks have a big role in reducing adverse selection through financial selection. As stock markets prices continued going down in the early 1930s, investors were experiencing hardships in repaying their loans making more banks to close. By 1933, about one third of the banks had closed down. Adverse selection worsened with few banks to offer financial intermediaries and increased business uncertainties especially in the stock market. Information was not readily available to financial markets such that it was very difficult to determine investors who were likely to succeed. Financial markets therefore restrained from offering financial services. With such order of events, the depression became even more severe.

The banking system failed much and increased adverse selection and moral hazard problems. On learning that the stock market was collapsing, banks went ahead to collect collaterals from investors who had borrowed from them. The investors were however being faced by the challenged of almost worthless stocks putting the banks into more crisis. People who had deposited with the banks then moved to withdraw their monies to avoid the awaiting collapse in the banking system. The agricultural sector that could have saved the economy seemed less promising. Prospects of recovery of the economy were very low as firms net worth went down day after day. This led to more adverse selection and moral hazard problems making the economy slump more into economic contraction of the Great Depression. Adverse selection and hazard problems were further increased by the fact that the U.S. had a foreign exchange crisis as it avoided buying from European economies yet she wanted the economies to buy from her.

Conclusion
The Great Depression started by adverse selection and moral hazard problems leading to the stock market crush. More of these problems only led to increase in economic contraction. This cascade of events plus lack of proper government regulation worsened the Great Depression.