Financial services and the real economy

Last month I travelled to Vilnius to represent TheCityUK at the International Financial Markets Conference organised by the Lithuanian Financial Markets Institute and the Lithuanian finance ministry.

 The presentation I gave was very closely related to the theme of this blog—the intersection of the “real economy” and the “financial economy”, as I described it in the introductory post. This slide from my presentation, for example, explored the relationship between financial services and economic development:

Financial services and the real economy

The charts, which are from research conducted by the Federal Reserve Bank of St Louis, show the positive correlation between financial development and economic development, where financial development is indicated by the ratio of external finance to GDP; this is then compared to both output per worker and total factor productivity.

Of course, economists love to remind people that correlation does not necessarily imply causation. So I ended up talking through some examples of the ways in which financial development has been shown to influence economic development.

For example, financial development influences economic development through trade. Research from TheCityUK’s Independent Economists Group notes that countries with more sophisticated financial sectors tend to have more trade partners. The report explains that this effect comes about because “firms prioritise which countries they trade with based on how easy or hard that will be [and] [o]ne of the factors that influences how easy it will be to trade with a country is the sophistication of [that country’s] financial sector”.

The same report observed that financial markets can facilitate corporate restructuring. This is perhaps one of the most important examples of the link between financial services and the real economy, because it goes to the heart of one of the core functions of financial services—allocating resources efficiently. But the intersection between economics and finance also operates through policy, as our research observed; the report noted that financial markets can certainly facilitate the efficient allocation of resources, but that “other factors such as labour laws also have an important role to play”.