Summary: Where does finance fit into the economy? Time was that the real economy was considered the dog and the financial economy the tail. Except for the occasional bubble, the tail didn’t wag the dog. What people ate and how they dressed was critical; how the saved and where they invested wasn’t. Now it’s not so clear.A recent IMF study noted that the world produced an estimated $70 trillion in goods and services in 2010. At the same time, the world’s public stock markets were worth $47 trillion; public debt $45 trillion, private debt was worth $54 trillion; and there were some $110 trillion in back assets. That’s a total of $256 trillion, or almost 370% of the world’s GDP.Even if you allow for some overlap—banks owning public debt, etc.—that’s a lot of money! Now it’s not so clear, which is the dog, and which is the tail. And this is just cash investments. It doesn’t even consider the $640 trillion in swap contracts outstanding that are some $25 trillion in-the-money. Unquestionably, what goes on in the financial markets affects what happens in the real economy—through bank lending, public market access, pension fund growth, and consumer and business confidence.It didn’t used to be this way. In 1955 future economics Nobel laureate Harry Markowitz almost didn’t receive his Ph.D. because his work on portfolio selection wasn’t considered an economic topic. His ground-breaking insight on diversification and investing didn’t fit.It reminds us how much the world has changed. Today, if there’s a regular cash-flow, you can securitize it and sell the bond. If you’ve discovered a gene for a strain of lung cancer, you can patent it and start a company. We live in a financial age.It’s another reason that the Fed is right to consider asset prices in their deliberations. Because whether the tail wags the dog or the dog the tail, of the animal is shaking, someone had better take note.Douglas R. Tengdin, CFA Chief Investment OfficerFollow me on Twitter @GlobalMarketUpd
