This month, politicians in Washington are worrying — yet again — about global imbalances. No wonder: not only does the US need foreign investors to buy an ever-swelling pile of Treasuries, but China’s exports keep surging, fuelling western deficits. However, there is a second aspect to today’s imbalances that is rarely discussed: the size of global finance relative to the “real” economy.
This has fascinated me since I interviewed an Islamic finance scholar in 2007 who likened modern markets to a candyfloss machine. The reason? Real assets — like houses — were being used to secure debt that was then rehypothecated multiple times, partly with derivatives, just as sugar is spun and respun into candy floss.
That financial cloud looked impressive. But, like candyfloss, the value of its “real” assets was small — as we discovered when finance imploded.