Economy and finance not separate entities

A battle is raging within investment banks across the City. On one side, the economists typically have a relatively benign view of global economic prospects. On the other, those involved in the bond markets are often mired in gloom.

It is an unusual situation, since economists are notorious for practising the “dismal science”. Normally they can be relied on to take the gloomiest view on any subject relating to economics or finance.

But this time the situation is different. Although there is a consensus that the global economy is slowing, the key economic indicators are not looking disastrous. In contrast, those involved in the bond markets are depressed. They see a credit crisis involving many hundreds of billions of dollars of debt – no one is sure of the exact amount.

The reason for these contrasting perceptions is clear. Each set of individuals is reacting to the circumstances they find themselves in. Those in the bond markets have a front-row seat as the credit crisis unfolds. Economists, on the other hand, look more broadly at the economy as a whole.

As is so often the case, it will be reality that decides who wins the arguments. If economic growth dips only slightly, it should be possible to overcome the credit crunch with relative ease. The economists will appear vindicated. If the credit problems prove more intractable than expected, then the economic slowdown will be more painful. Those involved in the bond markets will claim victory.

However, it is misleading to see one side as being right and the other wrong. In reality, both sides are capturing only one side of the story. Although the economic situation could prove to be better or worse, neither of them is entirely right.

The division between the two reflects a fundamental problem common to discussions of the financial markets. Typically, the real economy and the financial markets are assumed to be autonomous entities. The relationship between them is rarely explored in detail.

This does not mean the connection is straightforward or simple. On the contrary, it is often convoluted and complex. But it should not be avoided either.

Understanding the truth about the credit crunch and the current economic difficulties means examining the full story. Not just finance or the economy in isolation, but how the two sides relate to and interact with one another.