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Finance and the real economy

The Lex column in yesterday's Financial Times picks up on the International Monetary Fund's recent self-evaluation, in a piece entitled "Ignorant economists". Specificially, Lex notes that one of the IMF's self-confessed shortcomings was an "inadequate understanding of how finance influences the real economy":

The greatest challenge for all economists is to understand the dynamics of the financial-economic nexus. It is a tough slog. Macroeconomists predict growth and unemployment rates with models that do not include financial variables. Prevailing financial models underestimated the chance of extreme events.

In line with many others, Lex appears to conceptualize finance as a force that is external to the real economy. The problem, according to this view, is that real economy models don't take into account this external factor. However, it is worth remembering, first of all, that we don't live in separate financial and non-financial economies - we have one economy. The distinction between the two can be a useful in our understanding, but they shouldn't be considered rigidly separated from one another. Furthermore, the way Lex presents the interaction between the two spheres is a one-way street, with finance affecting (negatively) an otherwise healthy economy. It doesn't seem to be imagined that the real economy could be influencing finance - in particular, that the stagnation in productive industry could be giving rise to a expanding financial industry.

Lex concludes that "policymakers must first find a way to shrink the financial world without destroying the economy". If you look at the measures taken since the crisis, you see a great timidity in tackling this issue of the balance between finance and non-finance.

On one hand, there is reluctance to "shrink the financial world", mainly because of this recognition that finance is so integral and a fear of just dismantling the edifice. What's overlooked is that financialization is the underlying, independent trend in stagnating developed economies. In other words, financialization has been helped by government policy moves, but the process of financialization has emerged, and will continue, if policymakers do nothing.

On the other hand, the solution to the problem of an overweight financial sector is erroneously assumed to be, as Lex does, to "shrink the financial world". Rather than erect obstacles to the growth of finance, it would be more fruitful to explore ways to grow productive industry. If the real economy thrives, finance would be restored to a less significant role. Financialization is a symptom, not the cause.

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