Atanu Dey On India's Development

The Amazing Economic Crisis

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.

Let’s pray.

  • http://broadbandblog.in Abhishek

    Excellent posts on the current situation. I would welcome more of these for your readers like me to better appreciate and understand the scenario. Keep up the good work.

  • Ike

    Very well put. This is an important distinction that bears repeating, and you nailed it succinctly.

  • Jayant

    Since this latest financial crisis the 64 billion dollar question is now worth absolutely nothing or 2 trillion, depending who’s asking and who’s telling!

  • Dsylexic

    It is disingenous to call it a financial crisis alone. There is a huge problem in job creation in the US. The mean contribution of the real estate sector to jobs has been around 9-10% over many decades.In the last 5 years,more than 40% of the jobs (=1.2 million jobs)created were in the the housing sector. A mean reversion is underway.Loss of jobs is not just a wall st phenomenon.

    The slide in the stock markets were preceded by falling housing prices caused by defaulting house owners.So there were indeed lots of turmoil in the real economy before it became a wall st crisis reflected on their toxic balance sheets. Ofcourse,it is all in a furious negative feedback loop now,feeding off each other.

  • http://www.cse.iitb.ac.in/~parijat parijatgarg

    “The total amount of assets does not change;”

    In a sense, it does, doesn’t it? Of course, that depends on how you define “total amount” which of course is a non-trivial problem. If you measure “assets” in term of their money value, then the total assets do change in a crisis like this one right?

  • prateeksha

    I heard that, apparently, the IT sector was not affected. Not much at all, infact. The reason being IT companies don’t need to borrow money from banks, bcos they have it, or their clients needs have remained the same or something.

    I too felt it. As I attended a career fair at my college, and the IT companies were ready to take me regardless of my major infact, while the energy, research and scientific ones were not so open. The IT companies even told me I could work part time , full time, from home or anywhere! They sounded as eager as any s/w company sounds anytime. That clearly shows … If nothing else works, get a computer degree !

    And, about the crisis situation… if you go by Micheal Crichton (keeping in mind his State of Fear) its all nothing but a big hoax planted by the govt to keep the junta (populace) under control. Nothing to worry about really :)