What about the real economy?

I sort of follow a bunch of economics blogs. Naturally they’re all very much preoccupied with the financial crisis. There’s a lot of debate about Keynesian multipliers, whether the stimulus will work, liquidity traps, bursting bubbles, and the like. If you step back, it appears to be a conversation about how to use fiscal and monetary policy to halt a vicious cycle of declining expectations fueled by financial instruments no one really understands – essentially an attempt to keep the perceived economy from dragging down the real economy (as it is clearly now doing). The implicit assumption often seems to be that, if we could only untangle the current mess, the economy would return to its steady state growth path.

What I find interesting is that there’s little mention of what might have been wrong in the real economy to begin with, and its role in the current crisis. Clearly the last decade was a time of disequilibrium, not just in the price of risk, but in the real capital investments and consumption patterns that flowed from it. My working hypothesis is that we were living in a lala land of overconsumption, funded by deficits, sovereign wealth funds, resource drawdown, and failure to invest in our own future. In that case, the question for the real economy is, how much does consumption have to fall to bring things back into balance? My WAG is 15% – which implies a heck of a lot of reallocation of activity in the real economy. What does that look like? Could we see it through the fog of knock-on effects that we’re now experiencing? Is there something we could be doing, on top of fiscal and monetary policy, to ease the transition?

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