September 30, 2008

Biggest Lesson From The Great Depression

Ilian Mihov, Professor of Economics at INSEAD, holds forth on the lessons of the collapse of the ‘golden age’ of the late 1920s.

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.

13 Comments

[. ] at The Indian Economy Blog] 30 Sep 2008 | Concerning Cross posted, Education, Trade & economy, United [. ]

Pragmatic

When you say all the lessons from the Great Depression seem to have been lost within three-quarters of a century. what specifically are you referring to?

What is the relevance to the Indian economy?

Comment by Prashant October 1, 2008 @ 5:10 am

@Prashant:

– When you say all the lessons from the Great Depression seem to have been lost within three-quarters of a century, what specifically are you referring to?

First, fiscal responsibility, especially in todays context, is extremely important for India to handle the fallouts of a bailout plan(which will eventually come). Will the FM/ PM cut down on his populist tendencies and virtual fudging of accounts?

Second, this is not a failure of the free market theory and the economic reforms of the 90s do not need to be rolled back with another set of physical controls with fiscal, monetary and tariff policies put in place now. That is a real fear of regressing back to an era of control.

Comment by Pragmatic October 1, 2008 @ 8:33 am

Interesting read.

-Nikhil

Masala Dosa Index

The parody of modern economics is money should act as measure of goods/services but today we use goods/services to measure the value of money

10 years back a Masala Dosa used to cost Rs.14 today the same masala dosa in the same hotel costs Rs.30. Value of masala dosa has not changed, one is good enough for keeping hunger at bay for 6 hours.

In South India the best measure of value of money is Masala Dosa Index, in North India we can use Alu Paratha Index to measure value of money.

Comment by Sujoy October 7, 2008 @ 6:44 am

Suppose if stringent lending norms, debt equity ratios, etc are

imposed in US from the beginning (like our RBI norms to Indians Banks)

and if US govt had very reduced and rational deficts ; and suppose if

US dollar is not the reserve currecy of the world ; and if Asian

central banks and all other investors in US T-bills had not lent so

much trillions to US to fund its massive deficts and spending sprees

(then US dollar value would have been terribly low). and if

if these had happened, how would the present scenrio be. and the crisis ?

and the accusation that this is the crisis if capitalism seems

certainly not capitalism or real free markets.

Comment by K.R.Athiyaman October 7, 2008 @ 11:13 am

A very good read.

Comment by Prats October 8, 2008 @ 1:10 am

a question to all the economists out there..how will this Great depression redux pan out.and I-banking as we know would change much. personally I dont think so..coz these institutions existed because these was a section of people who wanted returns way more than any index could provide and those will always be there..if not lehmann then some other bank(hedge funds now they are saying will take their place)

Comment by rahul October 8, 2008 @ 12:24 pm

Now lets see what Neel Kashkari can do to get things right. The entire world is looking at him.

The politicians are trying to coy the issue by not giving the intricate details.But the situation is very conspicuous.The cabinet should capitalize and find the alternative path for the recession in India other than relying on the american move.We have lot of fruitful path and the one in the forefront is the infrastructure development.I would like to suggest the FDR`s policy for the Indian retrenchment,where we can find a lot of opportunities for youngsters to have their pie.Lets pray that the politicians shall not play the vintage politics at this time and use the mud-slinging strategies to evade away as a scapegoat.

Comment by vignesh October 21, 2008 @ 10:57 pm

Hi Sujoy !your example ofMASALA DOSA INDEXis really a nice one .As we all are concerned with rising cost of living leading to heavy fall in the value of money has become a issue of concern for the masses.still the rate of inflation in India holds double digit figure ,recently it has reduced significantly from a high of 13%.

Comment by Anakshi November 2, 2008 @ 1:26 am

The economic development of a country is largely dependent on the monetory policy of the country.A good monetary policy may not accelerate the economic growth of the country but a bad policy may derail the economic development.

madhumita G.

UGC Academic Staff College.

Mumbai University,Dec.,08.

Comment by madhumita December 20, 2008 @ 10:19 am

how is it that good monetary policy is unlikely to accelerate the speed of economic growth

Comment by shirley December 20, 2008 @ 10:20 am