When I was a student, most of the economics courses focused on the real economy and money and banking. Finance courses were not as developed and not as important as they are now. Now, the financial side of the economy has grown rapidly over the last three decades and has become as important as the real side.
More recently, we had the Great Recession which was not caused conventionally by the real side of the economy such as housing and the business cycle but by the financial side such as bad balance sheets and financial innovations.
Then came quantitative easing, which has been practiced by major central banks in the world such as the Federal Reserve System, Bank of Japan, European Central Bank and People’s Bank of China. QE has inflated the financial side of the economy, but did not expand the real side by the same proportion. The gap between the real and financial sides has widened and the financial side overwhelmed the real side. Fiscal policy, which is more connected to the real economy, is much harder to use and can blow political winds that cannot be steered to real economic growth by politicians. Moreover, financial variables such as interest rates, exchange rates and derivatives move much faster than real variables such as GDP, investment and consumption. They have left the real variables behind, and we should expected the next recession to be caused by the financial variables and not housing, inflation, inventories, etc. as before.
Inflating the financial side has already created problems for itself and for the real side. In China, for example, reducing interest rates to stabilize stock markets is at odds with supporting the exchange rates. Any increase in liquidity to reduce the interest rates is at conflict with intervening in the foreign exchange market through selling dollars and buying the yuan. Expanding the financial sectors in U.S. and major economies is adversely affecting financial stability, it has worsened income inequality. Appreciating the value of financial assets has benefited asset owners at the expenses of wages and salary. It brought new regulations to the economy that helped curtail productivity and real investment. There is also a QE exit problem for the Fed, which has been brewing for some time. By dropping interest rate to zero, the Fed has no dry power to fight any future recessions. QE has encouraged investors to take more risks and businesses to borrow more money and engage in financial engineering. Banks, investment companies and other businesses now own oil storage tanks in Cushing, Oklahoma to trade oil when prices go up.
Globalization and communication seem to inflate the financial sector much more than the real sector, which has contributed to the widening gap and disconnection between the two sides of the economy.
Now the policy makers on the financial side are running out of tools with the much expanded and globalized financial sector. This implies that the fast-running financial sides in the world must run on their own and connected each other through globalization and competition and less with the real sides. This means the groping to a balanced equilibrium by the financial side will take a long time until the economic sides catch up. The obvious implication is we have to grow the real side and reduce the gap with the financial side without reducing the financial side. Trying to expand or tie up the financial side is not the best solution without expanding the real side. My recent research with doctorate students at Drexel has dealt with this issue.