What is the biggest lesson from the Great Depression? In my view, it is that monetary policy and the financial sector play a crucial role in economic development. Let me put it more precisely: good monetary policy is unlikely to accelerate the speed of economic growth – after all we have more income year after year because mankind comes up with new ideas, with new products, with more efficient ways of producing output. However, bad monetary policy can easily derail economic development. It is true for rich and poor countries alike.
Why are financial markets and the banking sector so important? Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.
Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers. On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.
And one thought like Ilian that this would be obvious to all the policy makers. However all the lessons from the Great Depression seem to have been lost within three-quarters of a century. It seems, to paraphrase Marc Bard, that politics [especially of the petty and partisan variety] eats policy for lunch seven days a week.
Originally published on September 30, 2008 at The Indian Economy blog and reproduced here with the author’s permission.