The best description I have found of how economics and finance interacted is by Anton Brender and Florence Pisani*. The two French economists describe in great detail how money from European and Asian exporters ended up in US consumer or mortgage debt and how risk was transformed in the process. The main point is that global imbalances would not have become so extreme if global finance had not provided exotic new instruments.
The paper is an excellent history lesson, but history means nothing unless we learn from it. Anyone who has been reading my commentaries knows my view that securitisation was the market response to too much capital chasing too few investment opportunities -- asustained and growing imbalance in domestic saving and investment. Chairman Bernanke avoids mentioning all this when talking about macromanaging the future -- he just wants better tools to regulate important nonbank players. Too rapid credit creation in a low inflation environment will, I gather, again get no response from the Fed. I gather the belief is that the market will regulate itself. Haven't we had enough of that. But enough of my words.
Mr. Munchau wraps up his commentary this way --
Without securitisation, the world cannot sustain such extreme imbalances indefinitely. There is no way that Wall Street and the City of London will recreate the pre-crisis levels of securitisation, even if we make no changes to financial regulation. Rebalancing is likely to occur eventually. The US will run a large budget deficit for a few years, which partially offsets the sudden increase in US private sector savings, but it cannot do this forever. It is theoretically possible that American households will have repaired their balance sheets in a few years and will return to binge spending by then, but I doubt it.
I am not comforted by this scenario. Both China and Europe are likely to continue with broadly the same policies, trying to rely on exports for future growth while failing to produce sufficient domestic demand. The noises we hear from Germany in particular suggest that politicians and industry are looking forward to returning to the status quo ante.
So if all we do is stimulate the economy in the short term through monetary and fiscal policies, and tighten financial regulation, we are not really solving the problem. We can regulate to prevent another subprime crisis, but another subprime crisis is unlikely to occur even we did not regulate at all.
In the absence of another credit boom, which is improbable given the weakness of the global banking sector, imbalances will contract one way or the other. Without an increase in domestic demand from Europe and China, there is nothing to take up the slack created by the saving of the US private sector.
Once the US stimulus expires, and the budget deficit starts to narrow, global demand will settle at a new lower level. Under those circumstances, it is difficult to see how the world economy can return to the pre-crisis levels of growth, or even close to them.
This is why we should be worrying more about global economics right now than about global finance.
Couldn't of written it better myself.