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486 PART 5 Finance

Financial Systems and the Economy

LEARNING OBJECTIVE 3
Understand how the health of the financial system affects the productivity of the
economy, including the roles of the IMF and the World Bank.

Financial systems are an essential building block to a healthy economy. During the
U.S. Great Depression, the world economy suffered an unprecedented collapse. In
the United States between 1929 and 1932, the Dow Jones Industrial Average (DJIA)
stock market index, representing the 30 largest U.S. firms, declined from a high of
381 to a low of 41. Unemployment surged to more than 25 percent. The financial
market panic spilled over to the banking sector, as more than 5000 banks failed,
many due to runs on their deposits by the public. Bank regulators were over-
whelmed by the failures. Many banks were closed and their assets and deposits
frozen until regulators had time to deal with the problems. Depositors commonly
waited more than five years to get their deposits out of closed banks, and many
depositors were lucky to eventually get back 50 cents for each dollar of deposits!
Most experts agree that one of the main reasons for the depth and duration of the
Depression was the massive failures of financial institutions, particularly commercial
banks. By disrupting the financial intermediation process, payments for goods and
services in the economy broke down, access to credit for business firms and con-
sumers decreased, and valuable relationships between firms and banks were lost. It
was a harsh lesson showing that our financial system plays an important role in the
real economy. Businesses need banks and other financial institutions to acquire
investment funds to purchase working capital as well as plant and equipment. Cut off
from capital funds, business firms must rely entirely on profits from sales to finance
their growth. Also, business firms need the financial expertise of financial institutions
to assist them in merger and acquisition decisions and other important financial
matters. Finally, businesses and consumers need banks to assist in payments for
goods and services. The payments system is essential to a successful economy.
More recent episodes of financial crises have occurred in Japan, Mexico, Russia,
Finland, Sweden, Turkey, Argentina, and a number of emerging Asian countries. In
financial crises, banks and other institutions can suffer losses, depositors can lose
their funds, and financial markets can become volatile. Another significant prob-
lem is that relationships between lenders and borrowers are damaged. Since large
firms typically utilize many alternative sources of finance, they are less affected by
problems with specific lenders than small firms. Normally, small firms depend
entirely on banks for financing. If the bank-firm relationship is broken, small firms
can be cut off from credit and forced to reduce their business activities.
Timely intervention by the national government, as well as international agen-
cies such as the International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (IBRD or World Bank), can reduce the ill effects
of financial crises. In this way permanent damage to the economy from which it
would take many years to recover can be limited.
The IMF and the World Bank were established in 1944 as agencies of the United
Nations. These public institutions were set up to promote international monetary
stability and international trade. The IMF monitors exchange rates, makes short-
term loans to countries experiencing financial difficulties, and lends technical
assistance to countries also. The World Bank offers long-term loans to countries for
development purposes. Up through today, it has loaned more than $200 billion to
over 100 countries.
More than 180 countries are members of the IMF, and as members they support
it with monetary contributions. In the 1980s and 1990s, the IMF increasingly

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