Why should the “real” economy be affected by chaos in the financial sector?

Brad DeLong on the linkage between the real world (where people make things and provide services) and the financial world (where people move pieces of paper around). The linkage has always struck me as overly strong, although intellectually I understand it. (I studied economics at MIT when Bob Merton and Fisher Black were active instructors there. I was required to believe it makes sense.) He provides a good reminder of why the linkage exists, and its effects in setting off the current recession. An excerpt:

This crash in prices of risky financial assets would not overly concern the rest of us were it not for the havoc that it has wrought on the price system, which is sending a peculiar message to the real economy. The price system is saying: shut down risky production activities and don’t undertake any new activities that might be risky.

But there aren’t enough safe, secure, and sound enterprises to absorb all the workers laid off from risky enterprises. And if the decline in nominal wages signals that there is an excess supply of labor, matters only get worse. General deflation eliminates the capital of yet more financial intermediaries, and makes risky an even larger share of assets that had previously been regarded as safe.

via Project Syndicate – The Fairness of Financial Rescue.

(More discussion in DeLong’s blog

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