Growth of Finance and its implications on the Real Economy

Booms and Bubbles in the Emerging Economies

By
Saumil Sharma
MA, Global Political Economy
University of Sussex, UK
ABSTRACT
This paper is an enquiry into the growth of finance since 1970s and the effects of this
growth in the real economy. Financial growth has always been an important aspect of the
most popular problematique of the political economy, the globalization of finance. While
financial growth has been prominent in the core countries where financial institutional
network has grounded its roots, but these models of western financial growth have affected
developing economies by sudden financial developments often leading financial bubbles
which have translated into economic crises. This analysis brings forward the cycles of boom
and bust in financial economy as well as real economy, with a historical perspective on the
process of financialization. Process of financialization tackled here is inclusive of the various
forms of financial developments since the 1970s bringing different forms of growth and
crises in emerging economies in different regions of the world. The history of financialization
has implications on the patterns of financial liberalization in different periods of time, which
have been used to provide the legitimacy and relevance of the relationship between real
economy and financial economy. This paper attempts to bring an argument on the inherent
fragility in the financial economies of emerging markets and links it to historical references
of the financial crises included for analysis. Further this paper strives to highlight the
relationship between financial bubbles and economic and political paradigm in which the
financial processes are undertaken and have direct consequences, both positive and
negative, on it. Some facts have been included for the recent growth in emerging markets
in Asia, especially India and China, in respect to the financial and real economic growth in
these economies that has existed concomitant with the financial fragility of the global
financial system.
INTRODUCTION
Financial economy stands today as dominating the role in global economic order. The
finance sector, although having a long history, saw a much quicker growth since the early
1970‟s. Within three decades finance has established its mark in he global order today with
substantial shift in the perspectives of state and the real economy towards the role of
finance. Global financial sector has experienced multiple periods of extreme growth as well
as sudden collapse during the short period in which it has gained a significant role in
defining the world economy. As it appears, finance leaves no alternatives to capital flows by
creating strategic imperatives to be pressed upon the real economy and the industrial
establishments in the developed and developing economies.

A neo-liberal view point criticizes state intervention as the disruption in the natural working
of the Financial Markets. Finance, as it is assumed often, to have taken its place in the
global economy by relegating the real economy, presenting new opportunities for economic
growth based on market fundamentals alone, is one of the prominent understandings of
financial growth. This view is suggests the existence of financial markets in a vacuumed
space with no relation to the social or political fabric that exists within the real economy. A
political economy analysis of global finance can be used to contradict the consideration of a
disembedded market operation from the real economy. This analysis discuses the reasons
behind financialization and the architecture within which financialization was initiated and
pursued.

Literature on financial growth is often of the opinion that the markets are self-sustaining
which grow as a natural phenomenon having self-correcting capabilities. The assumption
that growth in financial sector is achieved through an independent nature of finance and its
clear division from the real economy is of a problematic nature. Such an explanation
disregards the historical analysis of a social and political framework in which the finance
industry settles itself. The effort is to bring to light the existence of certain social
circumstances combined with the deregulation efforts of the states to build a historical
relevance of social and political conditions under which the finance sector grew rapidly and
has sustained impacts of abrupt change during the three decade long period under study.
For this purpose a major focus has been provided on the different forms of financialization
that occurred during different periods under study. This provides the argument for looking
at financial growth as a political process which has a complex relationship with the real
economy.

The literature involved in this analysis has been incorporated in view of tracing the
development in the financial sector in the East-Asian economies during the 1990‟s and its
implications for policy and financial fragility. Reflecting the implications on the growth in
Indian and Chinese financial markets and their real economic growth provides a
contemporary example of financial fragility. The literature reviews a historical process of
financialization from the arrival of new forms of electronic money till the most formidable
form of financialization that the global economy is currently experiencing.

The problem lies in the assumption that the emerging economies of Asia have face
consequences of a natural process of development in terms of economic growth and political
instability has been the underlying reason for the crises in the past. Financial growth in
these economies have political and economic constraints which reflect in the everyday social
life of people, more severely negative during the crisis periods than it reflects positively in
the financial rise periods. The problem tackled in this paper requires a deconstruction of the
political and economic sphere in which process of growth and development in finance as well
as the real economy takes place that can bring forth with the ambiguity behind the
understanding of it as a „natural‟ and „neutral‟ process.

1. Growth of finance

1.1 What lead to the financialization of economies?

During the 1970‟s the global economy saw a new development in the form of electronic
money. It evolved into this new form with the IT revolution, creating new dimensions of
storage and exchange of money at different levels in the major economies, ranging from
individual consumers to large scale financial institutions. Due to this transformation a
majority of the opinion in the concerned literature is of a standpoint that new forms of
money pose a threat to the existing form of world order and undermine the role of states in
both controlling the flow of money and exercising power over monetary matters.

Helleiner, in his critique on this strand of thought, expresses that there is more to
understanding the new forms of money and its interaction with the state than to constrain
the debate on control of money by states. Money, even in its more confirmative paper
forms, has not always been strictly locked under state control. There has been money
laundering [], illegal trade and exchange, etc. which underlines instances of state
inefficiency to fully control the flow of money at any point of time in history. So, the mobility
of money is not significant support to the idea of a transformation of world order and global
economy.

The more important aspect of electronic money and its ever pervasive nature is an
underlining factor of the growth of financial markets around the world. As Helleiner puts in
his own words: “The IT revolution has, after all, coincided with a period when the most
powerful states have liberalized their external capital controls completely”. Although, he
expresses his decent from completely basing the process of liberalization on the compulsive
pressures on the states in the face of what he calls „competitive deregulation‟ pertaining to
the extreme mobility of new money forms.

On the other hand, Joel Kurtzman argues that impact of technology developments is
different between finance and the real economy by providing a world view in which the new
forms of money have created a separate universe in which it breaks all natural boundaries
of state control and regulation over its appearance to the world and its implications on the
real industrial growth. The author maintains an extreme focus on finance as it exists rather
than going into the depth of its rise and growth through relevant state response to the new
forms of money and the state domestic policy not being ignored as an irrelevant concept in
this new era, but as being a very important mechanism through which the finance industry
has grown, stabilized and reinforced itself into what we observe today as the integrated
Global Financial Markets. It seems as if the development of new forms of money was an
intrinsic demand of the growing world of finance. As the financial paradigm was growing, so
was the demand for faster and intangible modes of monetary exchange. If framed on how
far did the real economy account for such a demand, it looks grim in the face of a severe
demand that rose from the finance industry. The free flow of money can be seen as both the
result and the premise of the growth in finance and provides a reason for the growth of
financial economy overshadowing the role of real economy. At such a pace of transfer of
funds and large sums of money proved utterly beneficial for financial growth in the face of
rising state concern over foreign capital flows and the efforts of finance industry to break
free from the constraints of state domestic policy.
In the words of Martin Konings, who criticizes the neo-liberal viewpoint of the growth of world
financial system as a self-sustained self-regulating entity, the financial setup of the world should
be looked at as: “It is widely understood that markets are not a natural phenomenon and that it is
not only economic logic but rather the configuration of economic and political interests and the
institutions that determine the precise relations between the state and economy at any given
time“.

1.2 How did Financialization occur?

The debate on the how did financialization occur is explained differently in the various
strands of thought. These different viewpoints are an attempt to break the assumption that
globalization of finance has been natural and relatively autonomous without any social or
political fabric within which it situates and reproduces itself. A classification provided by
Philip Cerny distinguishes between three different types of explanations. First being a
market-based explanation, proponent of which is neo-liberal market approach of self-
regulating financial system which is most efficient without any regulation and state
intervention. Second, a more institutional-technological explanation, projecting the role of
technological innovations within finance like new forms of money and financialization being
propagated by the imperatives of technological advancement creating a new era for world
economy whose economics is beyond any accountability to the political or social processes
that govern the institutional framework of finance. Third, more political explanations,
provided by Helleiner and Sobel in their sub-divided interpretations of the one reality, i.e.,
financial globalization.

Helleine, in the political economy analysis of the financialization process, puts

financialization as a consequence of conscious state action towards liberalization and
promoting the global financial architecture through ideas like economic cooperation and
integration of financial markets. His approach argues that active state policy decisions and
its promotion of finance through granting freedom to market oriented operations has been
to a great extent the driver of the financial globalization. In his opinion the states
deliberately refrained from capital controls. In Helleiner‟s explanation he, very importantly,
notes that the continued attractiveness towards financial liberalization of states while the
world economy almost regularly faced different financial crises has been the combined
efforts of the states and international organizations like the BIS to come to rescue and
reinforce legitimacy of financialization. While Sobel argues that the financial liberalization
was a consequence of the dominance of US financial markets and institutional framework
which came to be replicated by other states in order to gain certain incentives, although
both approaches, of Helleiner and Sobel, converge at some points to identify that financial
globalization was motivated by domestic incentives which served some objectives of
national interest.

Although these approaches certainly donot provide a direct causation to the process of
financial globalization and to the process of financialization, in a broad sense they provide
the most general form of explanations. Benajmin Cohen in his argument on the ressurection
of global finance provides a comparative analysis of different approaches and how they
diverge and converge at some points to explain financial globalization. He has added to this
debate a strong viewpoint by providing a hint towards a form of dialectic at work in the
relationship between market forces and public policy. He states that it is important to view
the different approaches within a complex framework for investigating their underlying
linkages.

Eroding state control over capital flows, not entirely a result of the technological innovations
and the new money forms, has its roots in the transformation of the global economic order
as a response to the changes in US domestic and international policy during the 1970‟s and
the 1980‟s. Goodman and Pauly argue that capital controls had become increasingly
unattractive, one due to capital flight by multi-national corporations to offshore[] Euro-
currency markets, second due to the pressure on foreign exchange reserves faced by
governments to maintain exchange rate stability with unregulated flow of capital and
continue with domestic policy autonomy[]. In the words of Goodman and Pauly: “Current
account deficits, capital outflows, weakening of exchange rates, and depleting reserves
often go together; when they do, governments must either adjust their policies or adopt
controls before the loss of reserves is complete. In contrast, governments facing an obverse
situation find it easier to abandon controls since their reserve position is not threatened.”

Robert Brenner‟s analysis on this period is the end of a long boom post-WWII which ended
into a long cycle of economic downturn encompassing all major developed economies.
Developing economies were also engulfed later as a consequence of the developments in
finance and increased flow of foreign capital into these economies. Brenner posts an
argument against the most embracing explanations for decreasing rate of returns and
incapability of states to regulate for a revival of increase in profitability. He underlines that
from the mid-60s the core economies like that of the US, Europe, and Japan were
continuously struggling with the problem of stagnation in profitability levels of the
manufacturing sector. Although, there was rise in productivity the conditions of „over
production‟ and „over capacity‟ (Brenner, 2002) plagued the international markets for
manufacture goods. He rejects productivity, technological exhaustion, and real wages as the
basis of a decreasing profitability during the 70‟s and the 80‟s, but instead suggests that the
underlying problem was international competition among major manufacturing economies.
The the paradox of International Competition created a condition of reduced rates of return
due to extreme pressures of losing international export market share in the face of long
sustained problem of over-capacity over-production6. Where at the same time this
simultaneous growth was a major reason for falling average rate of returns which did not
allow the creation of any surplus reserves to create new investment for maintaining the
increase in supply in response to the state subsidy towards creating a demand. The state
borrowing was high during the decades of 70‟s and the 80‟s with an exception of the short
lived strict monetarist policy experiment in the early 80‟s. The state deficits were increasing
due to increased borrowing, especially in the US which created the grounds of revaluation of
many major currencies against the dollar, making exports to US market more difficult on
the top of US domestic market protectionist policies. But this also created a situation of an
ease in the prices of US assets for foreign buyers in the international market.

In words of Robert Brenner: “In response to the impasse of the international manufacturing
sector at the end of 1970s, resulting from the deepening of the crisis of profitability
throughout the previous decade, governments across the advanced capitalist economies
sought to ease into financial activities and pave the way for higher returns. To do so, they
initiated not only a permanent war against inflation, but also a far-reaching process of
financial deregulation.”

Considering a relationship in the framework of financial liberalization policies adopted by

states with the increased mobility of capital flows, transforming the world economy, defines
certain conditions for the growth of finance as a major part of world economy in the
following decades. How these conditions surface the financialization process as an integral
part of relating public policy to market oriented operations, legitimizing imperatives of free
market capitalism is the question to be tackled in the following section.
2. Historical View on the Financialization Process
The division provided by Eichengreen and Fishlow in their analysis of the financial crisis of
the 80s and the 90s is the build up till the Latin American crisis was the era of bank finance
or international private bank lending and in the 90s up till the Asian Crisis was the era of
equity finance or portfolio investments[]. A breakdown in terms of the political economy of
International Finance from the 70s to its contemporary forms substantiates the inevitability
of the apparent consequences of financial deregulation[] and financialization of the world
economy.

Sources of private bank lending in the 70s were an upshot of domestic political choices and
macro-economic adjustments made by certain economies, especially the US. In the 90s, the
Asian economic growth was the motivation for increased portfolio investment in much larger
proportions as compared to foreign direct investment or the traditional government lending.
Today we witness a much deeper form of Financialization where credit generation has been
extended to people‟s daily lives with enormous growth of pension funds, the new
innovations in the form of credit default swaps, securitization of student loans, etc. A
historical analysis is presented to understand the fundamental reasons behind these
financial developments since the 1970s.

2.1 Intermediation of 70s and 80s

The oil-importing nations of Latin America were facing increasing oil prices concomitant to a
falling demand for their exports in the core countries due to inflationary pressures faced by
importing nations. It resulted in the increasing deficits of most of the Latin American
economies. Their debt levels were on a rise and all these economies were willing to borrow
foreign currency (US Dollars) from the international market to service their deficits and to
buy capital goods from the core economies. With the fall of the Bretton Woods Agreement
there were structural changes in the world economy like devaluation of the US dollar,
floating of accumulated US dollars by other economies in the international financial system,
lowering of world interest rates due to heightened liquidity, etc. With a floating exchange
rate regime and a devalued dollar, in 1973 the first oil embargo was exercised by the OPEC
nations which lead to a sudden price appreciation of oil. This lead to a an over-accumulation
of US dollars in the oil producing nations. These accumulated US dollars were subject to any
further volatility in exchange rates and interest rates, and therefore, the international
financial system was facing acute increase in investment through the inflow of „Petro-
Dollars‟ by the oil producing nations. International Banks were acting as intermediaries[] to
meet the demand of the emerging markets, predominantly servicing the demand from Latin
American economies, by lending foreign capital raised by the petro-dollars.

Therefore, the period 70s comprised of increasing international private bank lending
towards the increasing demand of developing economies in Latin America. There can
observed two distinctions for the reason that most of this private bank lending, as much as
80% of the total US banks capital outflow in the late 70s, was focused on Latin America.
First, the International Banks considered the lending as a part of the sovereign national debt
that „will be paid back‟ and thus provided foreign capital in excess of the demand, creating
record levels of debt in Latin America by the end of 70s. Second, neither the banks nor the
Latin American economies had a long-term vision of the consequences of any interest rate
hikes as majority of the borrowed money was based on variable interest rates. The
investment in the Latin American economies was directed towards servicing deficits and
imports like capital goods and there was a severe lack of any productive investment of the
foreign capital.

In 1980 Reagan government‟s decision to fight high levels of inflation led to a high increase
in the US interest rates which reflected as increase in the world interest rates in a very short
period of time. This inflated the total debt repayment by Latin American economies, some of
which found their debt repayments up to five times the original value. The recession of
1981-82 lead to fears of debt default by Latin American economies, which was hinted by
declaration of 120 day moratorium by the Mexican Government on its debt repayment. In
1982 the international private bank lending almost ceased and the Latin American
economies were falling one after another on failing to service their debt obligations to the
syndicate of international private banks. All through the 80s there were IMF adjustment
programs, implementation of which resulted in heavy social costs in the Latin American
economies. The effects of this financial turmoil within intermediaries and the fear of
threatening instability and collapse of the international financial system brought together
the regime of IMF and World bank which was to ensure debt repayment through structural
adjustments and rescheduling of the Latin American debt by imposing involuntary
liberalization, opening of economies, and privatization at the cost of social spending,
domestic welfare, inflation, and unemployment.
2.2 Disintermediation and Securitization of late 80s and 90s
In the 1990s there was a fundamental shift in the financialization process. There was a
return of lending to Latin American economies, a rise of portfolio investments in Asian
economies and further financial liberalization of the East-Asian economies to attract
increasing foreign capital inflows. The governments of the East-Asian economies,
particularly Indonesia, Taiwan, South Korea and Thailand, were freeing capital controls and
following the Washington Consensus policies while they were experiencing growth in
productive sectors of the economy. Barry Eichengreen and Albert Fishlow in their analysis of
capital flows in 1990s argue that majority of the private capital inflows into these economies
was the portfolio investments by pension and mutual funds, especially from the US. Low
interest rates in the US during the early 90s created an incentive for fund managers to
invest in high yielding financial markets of the Asian economies. The continuous increasing
portfolio investment was enhancing the creditworthiness of these developing economies
which were already under a burden of floating-rate debt.
In 1994 the situation of the Mexican economy with its political instability, increasing interest
rates, size of the current account deficit, and failure of investment to balance out the capital
inflows made Mexico a less attractive place for portfolio investment and the capital inflows
almost ceased completely. The government of Mexico put efforts to maintain the status quo
even without the foreign capital inflow and used its foreign reserves to prevent the Mexican
currency peso from depreciating did not last long and the peso was devalued by 15% along
with a Mexican stock market crash.

Asian economies, even after a catastrophic fate of the Mexican government‟s attempt to tie
its credibility to a fixed exchange rate, maintained almost fixed exchange rates and saw
further inflows of capital. Asian economies faced a similar currency crisis in 1997, although
there were some dissimilarities in the nature of growth within the two regions of crisis,
Mexico and Asia, along with the dependency of Mexico on short-term borrowing was pivotal
to the fragility of their financial system where as in Asia the problem originated with a loss
of confidence condition in the banking system of certain economies.
As Stephan Haggard and Andrew McIntyre outline the reasons of the occurrence of Asian
crisis based on the following conditions: First the extreme high levels of lending with
increasing portfolio investments coupled with bank lending and foreign direct investment.
Second condition was that the Asian economies had opened up their capital accounts during
the liberalization wave in the 80s and continued to do so to a greater extent. Third is the
tagging of government‟s credibility to maintain fixed exchange rates which created the
problems of overvaluation followed by speculative attacks on these currencies. And the
fourth, as the author claims to be a systemic argument for the crisis underlines the
contagion factor which led to the spread of currency attacks and loss in confidence in asset
market from one market to another.

The most important thing to underpin while focusing on the Asian crisis is the vulnerability
of the government‟s credibility to maintain sustainable capital accounts in order to continue
with the growth pattern of the early 90s. Weather a fixed exchange rate is sustainable is
dependent on many factors which go beyond the outlook of the government‟s policy
paradigm. Jeffrey A. Frieden in his essay on the politics of exchange rates indicates that it is
dependent on a government‟s ability and position within the economy and the political
sphere to support the exchange rate levels. He argues that exchange rate policy is affected
by certain special interest groups within the economy that have their strong incentives to
attempt for a favorable exchange rate. All monetary policies will affect different sections of
the society in varied ways, so during the 1997 period the Asian economies faced extreme
pressures from the capital markets to pursue policies which were economically
unsustainable, the real economic conditions within these economies put pressure to pursue
policies which were politically unsustainable.

The unholy trinity, a concept which is extremely popular in the political economy literature,
provides a reasonable argument for the instability that arises in fixed exchange rate
commitments. Between capital mobility, fixed exchange rates, and domestic policy
autonomy governments could choose only two of these aspects. Because when the capital is
mobile the governments are always under pressure to prevent the capital from flowing out
by maintaining low inflation. In order to fight inflations the governments can exercise to
increase interest rates which affect the domestic spending and increases level of
unemployment. Another effect arises in the form of government and corporate debt
repayment becomes costlier. This creates internal pressures on the governments to
compensate these effects with a little rise in inflation, but the investors would take the
capital abroad as inflation creates an appreciation in asset prices. This would in turn lead to
a fall in the value of currency in the international market. If the government decides to
continue with an fixed exchange rates then they would have to continue with rising
unemployment and high interest rates to maintain the attractive financial inflows. In order
to achieve fixed exchange rates and maintain stimulus in the economy by having domestic
policy autonomy the government will have to ensure the prevention of investors taking their
capital abroad by putting capital controls and exchange controls, thus giving up the aspect
of capital mobility. In other words, financial capital has been a stimulus to growth in the real
economy but at the same time it creates major vulnerabilities for states, especially
developing states, to maintain a favorable political position to overcome possibilities of
speculative attacks. Historical instances suggest that governments have used foreign capital
reserves to support their currency value in the international market against a speculative
attack and still fail to maintain fixed exchange rates because in essence the foreign reserves
are only limited and it is clearly known to the investors.

3. Contemporary Models of growth in Asia - India and China

The more contemporary forms of financialization are like the unforeseen growth of
Mortgage-Backed Securities in the US market, surpassing the total capital generation by
even the US Treasury Bonds after the year 2002 and the financial expansion towards
inclusion of new streams of illiquid assets, like „remittances‟ and „micro-credit‟, which can be
securitized to bonds and other debt instruments that are liquid and ready to be sold at the
discretion of the investors in capital markets. This financial inclusion is an effort to legitimize
and reinforce the role of finance in the world economy and give strength to the continuation
of financial globalization and integration of markets, creating more avenues for this massive
paper wealth[] generation with expected profit generation in the future.

Just to show a contrast between the Financial growth and the real economic growth in
emerging markets like India and China the following statistics have been provided –

India China
Year GDP % change GDP % change
1996 373.42 5.8% 816.41 16.6%
1997 406.86 9.0% 898.24 10.0%
1998 409.43 0.6% 946.32 5.4%
1999 436.78 6.7% 991.36 4.8%
2000 458.42 5.0% 1080.74 9.0%
2001 471.27 2.8% 1175.72 8.8%
2002 495.00 5.0% 1270.67 8.1%
2003 576.12 16.4% 1416.60 11.5%
2004 661.05 14.7% 1649.39 16.4%
2005 749.44 13.4% 1843.12 11.7%
2006 814.07 8.6% 2040.33 10.7%

4. Financial Fragility and the Real Economy

Financial Fragility is the concept of self-fueling financial asset bubbles which are self-
fulfilling and with intangible factors like investor mood swings these bubbles can bust
creating dramatic consequences for financial markets, which spill over to the real economy
which depend on these markets. Jim Stanford, in his words, comments the following:

“The boom and bust process can occur independently of the underlying economic
fundamentals of the particular companies involved, yet ironically the cycle can have
important effects that extend beyond the paper economy to the real investment of the real
capital and the real production of goods and services. The financial ups and downs are
entangled in a complex, dynamic web of relationships between asset prices (like stock and
bond prices), interest rates, and the subjective confidence of company managers and
consumers in the real economy. Economic growth itself becomes subject to the whims of
the market.”

In other words, with an initial asset price rise, weather based on real fundamentals or
subjective expectations, the investors will buy assets to make profit by selling them in the
future at a higher price. But these expectations of future profits are not always serviced by
the financial markets. It would be too simplistic to discuss financial rise and fall affecting
asset prices concentrated in the financial institutional framework. In reality, it is a complex
relationship between real economy where real goods are produced and real investment
takes place and the financial market where these asset prices are speculated. This complex
relationship forms actor expectations in the financial markets based on economic
fundamentals, but overvaluation of assets in a financial market are responsible to create
these bubble effects within the real underlying fundamentals, thus creating drastic
consequences, beyond the financial arena into the real economy, when actor expectations
are not met by financial markets.

Adam Harmes explains in his argument on financial fragility that price overshooting[ ] is a
consequence of the false signals provided by the ill-representation of the „true‟ value of
assets when markets do not operate efficiently causing poor economic synthesis and
decisions. Overshooting of a currency, as in the case of the 1994 Mexican Crisis, is based on
the high value of the currency relative to its true value in the international exchange market
which creates a fundamental flaw in terms of overpriced currency. On due correction this
flaw creates a heavy devaluation of the currency leaving it into a negative overshoot which
leads to a crisis situation.15 Therefore, price overshooting is both economically and politically
unsustainable and hence questions the freeing of financial markets from government
regulations and the role free market in an efficient resource allocation by creating an
efficient supply and demand.

In Jim Stanford‟s summary of Minsky‟s analysis of financial fragility he focuses on three

important aspects that can be drawn. First, the wealth is a macroeconomic variable in itself.
That is to say that all the wealth creation in the financial sector remains invested in financial
assets in expectation of future profits. Although, this wealth creates more spending and less
savings as actors have become richer, though on paper. Second, the financial
intermediation, i.e., the role of banks and other lenders in the economy, speculators, fund
managers, etc. works in a cyclical manner with financial ups and downs. When the financial
markets are on the rise the, there is ample liquidity in the system to buoy the financial
bubble, but with the outbreak of financial downfall, the liquidity escapes and most sources
of lending freeze creating a a further negative effect to the already suffering financial
markets and the slowdown in the real economy. Third, financial instability has important
consequences on the real economy. With rising financial markets, the real economy
experiences increased spending and high levels of growth, but as the optimism of the
investors fades away there appear strong potential threats with severe consequences in the
real economy. A credit crunch, combined with ceased private bank lending and other
sources of liquidity create severe distortions in money supply for real economic investments.

The question now arises that how overshooting of asset prices create a bubble in the
underlying fundamentals, in other words, how a financial bubble is shifted to the real
economy. In order to explain such a phenomenon, bubble analysis of Minskian tradition
comes to argue that a slight change in the fundamentals themselves are used to
comprehend and justify a large appreciation in the asset prices, thus creating the price
overshooting. Now, actors in the economy may use the overvalued prices to base their real
economic decisions. This is what Adam Harmes notes as the wealth effect where an
economy as a whole tends to spend more and save less. Corporate borrowing increases due
to large stock appreciations, creating ease in borrowing due to available collateral.
More spending creates a stimulus in the economy which appears as an increase in the
income and earnings. Better earnings for corporations still lead to a further appreciation of
the already overpriced assets. So increased spending, earnings and growth with less saving
are conditions for a bubble to emerge with in the real economy, i.e., in the actual
fundamentals that underlie the asset prices. Such a bubble is not easy to pin down as it is
justified on the basis of increased spending thus creating growth although it is based on the
falling savings and increased debts of not only corporations and the government but also
households which tend to borrow on the basis of rising asset prices, like the real estate price
rise, reinforcing the wealth effect. This explains the economics of the bubble in financial
assets. But can a financial bubble lead to a bubble in the political fundamentals of an
economy?

To answer this question we will have to move back to asset price overvaluation. If the
government is pursuing a policy of capital mobility and fixed exchange rates, then there
would be pressures on the government based on any shocks which create an instability and
thus a need to defend the fixed exchange rate. To stability of the capital inflow by
investors, interests rates would have to be raised, creating recession and unemployment, an
unfavorable condition for political stability. Asset price bubble creates a favorable condition
by negating the need for government intervention temporarily. Increase in capital inflows
further appreciate the overvalued market which leads to overvaluation of the currency. Thus
governments, for some time, find no need to adjust interest rates or stimulate the economy
as a bubble in the economic fundamentals due to increased spending creates growth and
employment. Such a temporary state appears to be favorable for the government as it faces
no pressures for exercising policy autonomy. The rising levels of growth in the domestic
economy create a sense of confidence in the investors which overrates the government‟s
credibility to defend exchange rates and thus create a sense of political sustainability of
such a regime. This arguments helps explain the attraction of fund managers and other
institutional investors in the Asian economies in the 90s which ended in the crisis of loss of
confidence paving the way for investors to move the capital out from these economies,
resulting in heavy devaluation of these affected Asian economies.

5. Conclusion
In essence the finance industry has always remained embedded in the social and political
system. Even today, when economies have been massively deregulated, the role of finance
cannot be seen without reference to the real economy. The appearance of finance industry
is far more impressive in terms of the amount of capital flow that exchanges hands every
day through the stock exchange but it has to be understood that this money has no form or
tangible existence. Rather it is of a recycled nature, being constantly regenerated in the
form on new exchange with new economic agents. As for the case, the Banks today have far
more money in circulation than compared to the commercial banking deposits made by the
retail investors. This is possible by methods of securitization and re-securitization in
continuous cycles which creates enormous amounts of intangible credit which circulates in
the financial industry.

The historical references to financialization described in this paper bring out the importance
of the active political choices made by governments to pursue policies in favor of financial
growth. While there has been a divided debate with converging arguments on why the
states took initiatives towards deregulation of capital markets and what reasons lie behind
the attractiveness of financial capital, weather be intermediation of international private
banks towards Latin American economies or the sudden raging portfolio investment in the
Asian economies, the argument brought in this paper is based on the imperatives of
financial capital along with developing country policies being greatly influenced by certain
sections of the economy whose incentives are strongly tied to a specific policy setup.
Financial growth has not always been detrimental towards the growth and development of
emerging markets, but at the same time, these markets are always under the threat of
instability due to the inherent fragile nature of the financial world and the behavior of its
actors, investors, funds, etc. Robert Shriller‟s book on irrational exuberance tackles with the
psychological aspect of the investor behavior in financial markets. He underlines that
majority of the investors are indifferent to all the complex calculation of future profits and
risk involved in certain investments. Their actions are dictated by emotions, reactions to
media, and several other factors which never appear in the textbooks of financial
economics.

Finally, an analysis of the boom and bubbles in the financial economy with arguments on
financial fragility and the self-fulfilling nature of a financial bubble support the various
historical instances of crisis faced by emerging market economies. Implications of such an
analysis of these market economy and market forces governing the allocation for resources
represent that resources allocation definitely not the most efficient. Instead, it fuels the
creation of financial bubbles which later affect the real economy by creating unsustainable
conditions for economics and politics with in the economy.
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