Avoiding Another Financial Crisis

Stock prices had risen more than fourfold from the low in 1921 to the peak reached in 1929. From 1928 - 1929, the Federal Reserve had raised interest rates in hopes of slowing the rapid rise in stock prices. These higher interest rates depressed interest-sensitive spending in areas such as construction and automobile purchases, which in turn reduced production. By the fall of 1929, U.S. stock prices had reached levels that could not be justified by reasonable anticipations of future earnings. As a result, when a variety of minor events led to gradual price declines in October 1929, investors lost confidence and the stock market bubble burst.
             In 2008, the United States fell into recession following a rapid decline in housing prices and a consequent rapid contraction in credit. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. This encouraged speculators to enter into the housing market and as a result it drove up housing demand and continued to propel the upsurge in housing prices. However, once interest rates began to rise and housing prices started to drop moderately in 2006 "2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and adjustable rate mortgages interest rates reset higher. .
             The stock market crash reduced American aggregate demand significantly. Financial instability generated considerable uncertainty about future income, which in turn led consumers and firms to put off purchases of durable goods. A banking panic arises when many depositors lose confidence about future expectations and simultaneously demand their deposits be paid to them in cash.