Finance and Economics, Or Economics and Finance?

by Michael J. Howell7. March 2013 14:12

It is widely-accepted that financial markets respond to economic phenomenon. However, we see it the other way. Finance is far more important to economics, than economics is to finance. Think of it in terms of flow of funds accounting. Economics focuses on ‘uses of funds’; finance focuses on ‘sources of funds’. Sources naturally lead uses. Thus our research is always more interested in whether the pool of liquidity is actually rising or falling, rather than the prediction of whether or not more will be spent on consumption. Two corollaries of this work are that Central Banks do NOT set interest rates, the market does (2007/08 confirmed this), and that interest rates are not the ‘price of money’. Rather interest rates are the ‘cost of capital’ and they are high or low ultimately depending on the profitability of industry. The ‘price of money’ is the exchange rate. Thus, low US interest rates and a weak US dollar tell us that US profitability is weak and the Fed is loose. In contrast, low Japanese interest rates and a strong Yen tell us that Japanese profitability is weak and the BoJ is tight. This also explains why real interest rates are higher in Emerging Markets.


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