Was the Global Recession Caused Mainly Due to Finance ?

The title of this article might seem misleading at first glance. After all, the close connections between economics and finance mean that any economic crisis is financial in nature and vice versa. However, to set the question in context, it is worth noting that recessions can happen because of the fall in economic activity either due to the boom bust cycle or due to the gyrations of the financial markets. Often, recessions are caused due to a combination of both or the coming together of economic and financial factors. In the case of the great recession of 2007 - till now, it is clear that again the decline in the mortgage market was one of the reasons for the crisis that was exacerbated due to the rampant speculation on the sub-prime housing market by the big investment banks in the United States.

What compounded the matter further was that due to the flow of hot money across the world, once the markets in the US tanked, the contagion spread to the rest of the world quickly turning a made in the USA crisis into a global one. Of particular note is the fact that financial services has grown to be the major component in the economies of the west over the last thirty years leading to the economy being dependent on speculation and excessive risk taking.

The point here is that the gains in the wealth over the last thirty years went almost exclusively to the financial sector and not to the real economy. With manufacturing being outsourced to China and IT services to India, what little was left of the “real economy” evaporated in the West. This meant that the crisis that originated with the bust in home prices and amplified due to the derivatives that were built on top of this market soon engulfed the entire economy.

Further, even governments did nothing in the buildup to the crisis and in fact contributed to it by running deficits and engaging in risky economic behavior themselves. For instance, the fact that interest rates were kept at near zero levels for most of the decade in the run up to the crisis meant that the governments in the West were encouraging speculation and risk taking. Added to this was the humungous amounts of money that they borrowed to keep the government running in the absence of real economic growth meant that eventually when the bubble burst, there were no survivors. This has important implications for the way in which policymakers ought to treat finance and its relation to economics.

Though one cannot ignore one without the other, there has to be some moderation based on economic growth because of real economic activity and not solely because of speculation. This is the key take away for anyone who is concerned with the economy from this crisis. Hopefully, the lessons from this crisis would be learnt and the mistakes not repeated. For that to happen, first there must be a recovery based on real growth and not false illusions.

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