Every now and then I get to read stuff about the huge on-going economic crisis. But there is no economic crisis going on. It’s a financial crisis, not an economic crisis. I think it is important to make that distinction. The financial system is part of the economic system and it is an important part. But the two systems are not identical and cannot be referred to interchangeably.
Let me see if I can get this right. Let’s take the failure of a financial institution or a stock market crash. When things like those happen, the immediate effect is only on the financial and capital markets, not the real economy. What’s the real economy? The economy that you can “kick.” It’s buildings, and factories, and farms, and roads, and ports, and mines, and people, and stocks of goods, and so on. That’s real. The rest of the stuff is accounting. Money is part of the economy but it is not part of the real economy.
When the stock market crashes or some mortgage lender goes bankrupt, nothing in the real economy is lost. Houses suddenly don’t de-materialize. Factories whose ownership shares were being traded at the stock market do not suddenly rust into a heap of twisted iron and steel. Everything in the real world remains the same. What does happen is a change in the distribution of assets held by different people. The total amount of assets does not change; only the distribution changes.
Can a financial crisis have an effect on the real economy? Yes, of course. If an important subsystem of a complex system breaks, it is bound to affect the system. There are linkages between the two. But it takes time for the damage to show up. How much damage it will do depends on how the financial crisis is handled.
So how should it be handled? First of all, since the problem is financial, the solution will involve money. How and where to put that money is of course the 64 billion dollar question. Second, consumer confidence has to be regained. This requires leadership and wisdom, which is of course much harder to come by than money.