Central bank liquidity operations and the impact of monetary policy will be blunted if credit markets do not work and financial institutions cannot lend. Scarce liquidity makes banks’ short-term funding vulnerabilities painfully evident. Debt loads that looked sustainable during good times are less sustainable under crisis conditions. In the medium term, prices and quantities will adjust to correct imbalances.
However, that process can be very rocky for exposed players, with real economic costs. Perhaps the foremost lesson of the Depression experience is that a sequence of setbacks should be anticipated. In responding to the urgency of cyclical stabilisation, we need to recognise the underlying large structural adjustments underway. The debt build-up will take years to prune back down to sustainable and prudent levels.