Saturday, October 04, 2008

Forbes Magazine: "A Golden Age"

It seemed like it was never going to end – the rise of the economy, the increased prosperity, the bull stock market. Forbes magazine said it would be ‘recognized as a golden age of American industry.” This was in the summer of 1929, but then the US economy collapsed. From growth rates of between three and 10 per cent in per capita terms, the US economy imploded: contracting 11 per cent in 1930, another 9.5 per cent the following year, and then shrinking a further 15 per cent in 1932. Who would have thought that the Roaring Twenties would transform into the worst economic disaster of all time? Emphasis mine

Ilian Mihov, Professor of Economics, at INSEAD, suggests We should heed the lessons of the collapse of the ‘golden age’.

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.

Can this happen again?

It is unlikely this will happen today. But I used to think that it was impossible. The lessons of the Great Depression are so clear and vivid that it was unimaginable that someone would risk the stability of the economy just to gain votes from his or her constituency. Are these CEOs overpaid? Should they go to jail? Maybe the answer to both questions is “yes”, but it’s important to understand that penalising greedy CEOs has nothing to do with saving the macroeconomy. Many of the issues raised by politicians recently have to be addressed, but it is a separate debate and will involve separate legislation. Emphasis mine.

As I noted in the previous post, back in the dark mists of the last century I learned this in High School Economics.

HT: Pragmatic Euphony

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