Posted by: Dirk | July 8, 2010

A question of causality at the IMF

Here is an excerpt of a text coming with the Global Financial Stability Report
GFSR Market Update, which is available at the IMF:

Although the global economic recovery remains intact, progress toward financial stability experienced a setback in late April and early May. Spillovers between sovereigns and the banking system increased market and liquidity risks. Banks again have become less willing to lend to one another, except at the shortest maturities, especially to banks in euro area countries perceived to be facing greater policy challenges. Moreover, financial asset price volatility increased and investor risk appetite declined. Such financial risks have raised the chances of re-establishing an adverse feedback loop to the economy, though to date there is little evidence of this.

What I think I can read between the lines is that in order to save the world economy, you have to get back financial stability. Once you have financial stability, you will get a nice real economy as a byproduct. I don’t agree with this view. Financial stability is a result of good investments which depend on the real economy. If there is no aggregate demand, nobody will invest, hence money will stampede through markets looking for positive returns in vain.

To be more specific: financial problems will only go away if the economies start growing again. That was the lesson from the Great Depression, and we will have to learn it again if the IMF and the governments of the world continue down this road. The financial problems that we have today are the result of global imbalances and the belief in the US and elsewhere that there are no bubbles, that markets always work. Without fixing these underlying causes, the financial consequences will not get better.

You might hide financial stress with creative accounting, if you think – as Mr Trichet from the ECB – that a lack of confidence is all we need to fix. However, this kind of thinking comes from textbooks like Alice in Wonderland. Better than the Ayn Rand stuff that Greenspan was relying on, I’d say, but still not very scientific.


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