Wednesday, September 07, 2011

the financial sector and the real economy

RWER | The uncertainty precipitated by the lingering fallout from the financial, economic, and debt crises increases daily. Meanwhile, leading mainstream economists are being criticized for their divided positions on the correct diagnosis of and viable solutions for these crises. Classical economic growth theories were unable to predict these dilemmas, as they did not adequately take into account factors such as the macroeconomic impact of outsized financial sector developments. Classical economic models are still considered by many economists to be the correct tools for dealing with the consequences of the 2008-2011 credit crisis (“crisis”). Meanwhile, others view crisis as stemming from the global imbalances precipitated by the application of these classic macro models. This contradiction seems irreconcilable. A new approach is therefore necessary. In this review, we present an alternative growth model. Specifically, one which helps to analyze the interdependence between the financial and the real economy and which also yields analytical statements about the causes of crises.

Sufficient capital is the basic prerequisite for enabling economic processes. Innovation is impossible without the availability of adequate capital. Mainstream economic growth models assume that categorical positive relationship exists between the two. However, as the recent financial and economic crises revealed, there is a fundamental interaction between the financial sector and the gross domestic product (GDP) of an economy. The relationship between the two is, however far away from being linear. This is demonstrated in chart 1 forGermany.

In the case ofGermany, financial assets – measured by total bank assets – grew significantly faster than the gross domestic product (see chart 1). Interestingly, a tendency for stagnating and (in 2009) even falling growth rates forGDPcan be ascertained. Allow us a brief historic synopsis. At the end of the 80s there was a surge inGDPdue to the integration of the East German economy. At the same time, nominal assets increased due to the conversion of Ost-Marks into Deutsch-Marks. Afterwards,GDPgrew only linearly, while financial assets experienced massive exponential growth. As of the 90s, growth rates in the real economy fell by such a degree that capital could no longer earn the high returns of the past. As a result, capital increasingly gravitated to the higher return potential of the financial markets (equities, private equities, hedge funds etc.). This caused the so-called “savings glut,” a situation wherein too much capital is chasing too few investment opportunities. It is in this context that the term “financialization” is often used by economists. Financialization describes the process by which increasingly more corporate earnings and personal income result from financial transactions and not from real economic growth, i.e., increased production and related growth in employment.