2 Money, Finance, and the Economic System
- Garry Schinasi
- Published Date:
- December 2005
The examination of financial-stability issues requires considering the characteristics of finance that distinguish it from other important economic processes such as production, exchange, and savings and investment.9 For example, in monetary economies, although economic processes make use of some or all of the characteristics of money, finance is uniquely related to money. Similarly, while production and exchange involve elements of human trust, finance uniquely embodies uncertainty about trust. This is so because finance intrinsically embodies promises that can be broken, as between borrowers and lenders. In these and other ways, finance plays important and unique roles in facilitating other economic processes. Recognizing these unique aspects of finance helps to explain why it is useful to think of finance and financial stability as conveying externalities and, in some ways, public goods.
Finance and Its Relation to Money
The unique aspects of finance, particularly its elemental relationship with human trust, are examined in this section.
What Is Finance?
According to Webster’s Dictionary, finance is
(1) money or other liquid resources of a government, business, group, or individual; (2) the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities; (3) the science or study of the management of funds; (4) the obtaining of funds or capital. (Merriam Webster’s Collegiate Dictionary, 10th edition)
The following analysis will make extensive use of the first two definitions, and more use of the second than the first. These definitions are not entirely useful or complete, however. First, there is no sense of what the “system” accomplishes or how it fits into the broader economic system. Second, these definitions do not provide a sense of whether finance is an end unto itself or just a means to an end. As an industry, finance produces measurable value-added and creates jobs. But there are other, less direct and less measurable benefits that may, in fact, add up to significantly more of a contribution than the measurable value-added.
The benefits of finance—both as a process and as an activity—originate primarily from the ways in which finance enhances the overall efficiency of resource and risk allocation, both spatially and intertemporally. By helping the economy allocate resources to their best uses through time, and allocating risks to those most capable of managing them, finance facilitates and supports the processes of production, wealth accumulation, economic growth, and the prosperity of societies more generally.
Accordingly, and for the purposes of designing and managing financial-system policies, finance is primarily a means by which important functions of the economic system are facilitated or achieved. This does not mean that finance does not directly contribute to production or that it plays a subordinate role. Throughout history, the need and search for more, and more effective, finance often led to discoveries and innovations in finance that themselves had a lasting, even a great, impact on economic systems and their evolution, at times for good—at times for evil.10 Consider the positive, perhaps revolutionary, impact of the emergence of banking in Europe in the fifteenth century and of the invention of fiat money (and other forms of legal tender) in the seventeenth century.11 These core elements of finance did not exist during most of recorded human history.
Economies still endure that have not developed finance to a sufficient extent to reap these broader benefits. Moreover, even in mature financial systems, the benefits of finance cannot be taken for granted. When finance is not performing properly—even in highly developed financial systems—it is likely to be reflected adversely in the economy’s performance. The efficiency and effectiveness of finance in facilitating resource allocation may be reduced, such as during a “credit crunch;” or worse, the potential for market imperfections and systemic problems (or systemic risk) may be introduced, such as occurs during the onset of financial crises. (Briefly, systemic risk is the risk that an event will trigger a loss of economic value or confidence in the financial system serious enough to have adverse effects on the real economy. Chapter 5 discusses this concept in more detail.)
How Is Finance Linked to Money?
In monetary economies, finance is intimately bound to the unique services of money. While this may be obvious, it is not trivial, as examined in the following discussion of the roles of money and money’s relation to finance.
Services of fiat money
Although fiat money has no intrinsic value, it provides essential services that are part of every economic transaction in a monetary economy. Two of these services are as a unit of account and as a medium of exchange. The second role is more unique and defining than the first, in that fiat money—and more generally, legal tender—alone embodies the finality of payment in transactions.12 Until legal tender is actually received by a party to a transaction (including in the form of an electronic transfer to a bank account), there will be uncertainty about whether an economic exchange of full contracted value has actually occurred. For example, and as is obvious, the certainty of receiving full value is immediate in a simple exchange of a commodity for legal tender.13
More generally, any money that is universally accepted as a medium of exchange (or means of payment) facilitates trade and exchange. It could be a legally issued fiat currency, a commodity money such as rice or gold, or a derivative money—a bank deposit—that promises to pay a fixed amount of legal tender on demand (Tobin, 1992). Money facilitates trade and exchange by eliminating the timing of the receipt of income as a requirement for making expenditures. In this way, money removes an important individual constraint on economic activity.
Equally important, money facilitates efficient trade and exchange by eliminating the “double coincidence of wants” that is characteristic of, and intrinsic to, trade and exchange in barter economies.14 A barter economy hinges on the costly requirement of finding someone who possesses the commodity you want to purchase, and who wants to purchase the commodity that you possess. If you have apples and want oranges, you would need to search and find a person who has oranges and wants apples, meet at a specific time and place, and decide how much to trade at what price. You may have to find several individuals and meet in several places and times to fully satisfy your demand for oranges. The search and transactions costs in barter economies are very high.
In a monetary economy, no such search and transactions costs are necessary: all you need to do is find someone who wants to sell the good for money. Because of its universal acceptance as supplying a medium-of-exchange service, money makes the processes of trade and exchange more efficient by driving search and transactions costs to a minimum. Thus, money enhances the efficiency of trade and exchange.
It is reasonable to ask, if money has no intrinsic value, why is it universally accepted? The answer is both complicated and unsatisfying but it also introduces an important human element of exchange. In effect, money is used as the universally accepted means of payment because of the expectation and trust that it will also be accepted by others. Because of this trust, it is self-fulfilling that money becomes the universally accepted medium of exchange. Fundamentally, in providing a vehicle for the finality of payment, money as legal tender is an economy’s surrogate for trust in trade and exchange.15
A third service that can be provided by money is as a store of value. That legal tender can play this role is most obvious when the medium of exchange (the currency) is a commodity such as gold or silver coins. However, even for these commodity monies, it cannot be taken for granted that their values—their purchasing power—will be maintained through time. Unlike unit-of-account and medium-of-exchange services, the effectiveness of money in providing a store-of-value service cannot be decreed by the government that issues it, unless the government can ensure it will maintain the value of the currency issued.16
There are incentives to create substitute stores of value. It would be surprising in any economy if the distribution of money perfectly matched the trade and exchange needs among individuals. Instead, it is reasonable to expect that at any given time some individuals would have more, and others less, than the amount of money required. Some individuals might be willing to pay something for the use of the medium-of-exchange services of money to obtain purchasing power that they do not presently have, but which they expect to earn in the future. At such times, it would seem that conditions would be favorable for a temporary exchange of money in return for a promise (an IOU) to return it, if only the promise of return could be properly valued and priced, if not guaranteed.
What is unique about finance?
Because economic agents typically prefer not to store value for long periods in the form of money, private contracts between third parties—financial instruments—have been created that provide both the store-of-value service (ownership claims on future income in the form of financial assets) and the medium-of-exchange service (for example, one can pay for a meal with a check drawn on a bank) of legal tender. These intertemporal contracts voluntarily reintroduce uncertainty and risk about human trust, a defining feature of finance. On the one hand, the re-introduction of uncertainty distinguishes finance from the means-of-payment services of fiat money. On the other hand, it allows finance to create potentially superior near-fiat-money substitutes as stores of value (the most obvious of which is bank credit). Finance can do this successfully only to the extent that uncertainty about trust can be priced and risk-managed. As examined below, the creation of fiat money substitutes for intertemporal exchange is the essence of finance and financial activities.
How does finance differ from exchange? To see the distinction more concretely, consider the elementary example of an exchange of money for a perishable good, say an apple. In such an exchange, both the unit-of-account and medium-of-exchange services are obviously relevant. Ownership and possession of the two items are exchanged with no intention of reversing or undoing the exchange at some later time. The exchange of equal value, ownership, and possession is final. Legal tender is accepted because it embodies the value of the commodity at that time, and it is trusted by the recipient of legal tender that the money can be used in other transactions immediately.
In this common exchange, the store-of-value service of money is not playing a major role if it is playing one at all. However, suppose the recipient of the money does not expect to use it soon or is uncertain about whether the value of money will be sustained until such time as the money is needed. Then the recipient might seek alternative and superior ways of storing future purchasing power (wealth) in some other value-safe form, or even in an alternative that might enhance the stored value. This would require finding other individuals that want (or need) to increase the amount of money they possess, either because they need more of the medium of exchange or want to use money as a store of value.
Essence of finance. What would the provider of legal tender accept in return? The answer is, a promise to pay back and enhance the same value at some future date. This is finance: a temporary exchange of the means-of-payment services of legal tender—society’s surrogate for trust in exchange—in return for the promise of a superior store of value (See Table 2.1). Finance means giving up liquidity now for the promise of a future higher return.
|Supplier of finance||Sells finality-of-|
|Buys promise of superior|
|Demander of finance||Buys finality-of-|
|Sells promise of superior|
Unlike in instantaneous and final exchanges of fiat money for a commodity or physical asset,17 finance involves uncertainty and risk about human trust, the same element of trust that fiat money is designed to eliminate in instantaneous trade and exchange. However, in reintroducing this uncertainty, finance potentially creates superior stores of value that facilitate intertemporal exchange and other economic processes.
In finance, the initial exchange is followed by at least one other exchange between these two parties to reverse the initial exchange. This relationship in time between the supplier and demander of fiat money is based on the promise that the transfer will be reversed in the future: the initial exchange is not a completed transaction. In essence, finance is a temporary exchange of the finality-of-payment services of fiat money for a promise, and this promise involves uncertainty about human trust.18
More tangibly, debt contracts promise to pay back a fixed amount and, in most cases, a stream of interest payments. Equity contracts promise to pay back a share of the firm’s profits, either in the form of dividends, or through a rise in the value of the shares, or both. If there is a lack of trust or few ways of eliminating trust as a consideration in financial transactions (such as collateral or hedging opportunities, for example), financial activity will be quite limited between the parties involved.
While other economic activities and relationships involve elements of human trust, in finance human trust is an essential part of the activity. For example, trust is involved in a relationship between workers and business owners: the owner of the firm promises to pay the worker for production, and the worker promises to produce a high-quality product. However, this trust relationship differs from that in finance in several important ways. First, the promise in finance includes the possibility of the loss of principal (the amount of the loan); no such risk is typically taken on either side of the worker-owner promise. Second, the worker-owner promise involves an exchange of tangible items (goods produced for fiat money), whereas finance involves an exchange of a promise for fiat money. Third, the uncertainty associated with the worker-owner promise can be reduced significantly, in part by shortening the time between production and income payments to a week or two; in principle, workers could be paid every day, which would significantly reduce the promise element of the relationship.
More broadly, fiat money and finance provide different degrees of value-added as they supply specific services to members of society (see Table 2.2). In normal times, fiat money is a superior means of payment than are most forms of finance: both fiat money and finance can supply the service, but the reliability of vehicles that embody uncertainty about human trust clearly are inferior purely as means of payment, perhaps with the exception of bank money, a close substitute for fiat money as a means of payment. However, in normal times, finance has the potential to offer superior store-of-value services over those of fiat money, and in so doing offers superior services in facilitating intertemporal exchange. Both vehicles require the user to take some risk, but at least finance offers a higher reward.
|Unit of account||Absolute||Imperfect|
|Finality of payment||Absolute||No|
|Store of value||Useful||Potentially superior|
* * * * *
The analysis in this section, although elementary, aimed to (1) usefully examine the difference between money and finance, (2) elucidate the inextricable links between finance and money, (3) pinpoint the essence of finance, and (4) clarify the distinction between financial transactions and final exchanges of legal tender for physical goods and assets.
Finance uniquely complements the characteristics and qualities of money, for example, in the ways in which it facilitates (through lending) the preservation and potential growth of purchasing power through time, or in the ways in which it facilitates (through borrowing) the transfer of future earnings into present purchasing power. While these financial transfers through time could be performed, in principle, without the existence of universally accepted money, they would be performed with significantly less effectiveness and efficiency, and in significantly smaller amounts. Indeed, prior to the introduction of convertible monies in the eighteenth century, trade, exchange, and finance flourished in some parts of the world, but with significantly less breadth, scope, acceptance, and efficiency.
The discussion in this section also highlighted several unique and related characteristics of finance and financial activities in modern monetary economies:
- the temporary, intertemporal exchange of the finality-of-payment services of fiat money in return for the promise of a superior store of value;
- a trust agreement between counterparts;
- an intrinsic link to uncertainty.
Private and Social Economic Benefits of Finance
Because of its unique qualities, finance bestows enormous benefits privately and socially, and plays a fundamental role in facilitating the overall performance of economic systems. These private and social benefits and the role of finance have grown in importance in the latter half of the twentieth century. Throughout the course of the post-Second World War period, and beginning in earnest with the efforts toward financial liberalization in the late 1970s, the contribution of finance to the performance of economic systems has increased significantly in various dimensions, and in some cases immeasurably.19 Moreover, financial activities also have grown in importance and in some economies constitute a relatively large direct share of employment and production of final goods and services.
Employment and production in the financial industry is perhaps the most visible and measurable contribution of finance to the performance of real economies, but it may not be the most fundamental or important. Finance contributes in several other, perhaps even more important ways.
Facilitation of Intertemporal Economic Processes
Finance can be thought of as one important element of an economic system, one that facilitates the system’s ability to perform intertemporal economic functions. In this respect, finance can be likened to other parts of an economic system’s underlying infrastructure that together support (or in their absence, limit or inhibit) the performance of the economic system, such as the rule of law and enforcement of it. Similarly, finance provides fundamental services to the entire economy in much the same way that utility industries supply basic needs, such as water, power, and communications services. It is difficult to envision the benefits of modern economic life without these essential services; so too with the essential services of finance.20
Three important roles of finance in modern economies can be discerned.
First, finance enables the efficient allocation of real economic resources (now including human capital) at any given time and especially across time. It does so in many ways but one of the most important is by facilitating the matching of savers interested in postponing their consumption with end-user investors (most often through intermediaries) desiring to expand the capital base from which they can engage in productive activities.
Second, finance contributes to the performance of the real economy by facilitating the more effective management of the process of wealth accumulation for individuals, businesses, governments, and nations. Wealth or capital accumulation is one of the more fundamental requirements for a society to develop and grow. The more effective a society’s financial mechanisms for wealth accumulation and management, the greater the opportunities for this society to enhance and sustain development and growth over time, and to weather the negative impact of unanticipated and unavoidable adverse events.
In the more highly developed and modern economies, the process of capital accumulation extends to the accumulation of human capital. In many economies individuals are now able to borrow against future earnings to enhance the prospects of their future levels of productivity, either through secondary and tertiary levels of education or vocational and job training.
A third role played by modern finance—one that has become increasingly important in the global economy and financial system—is its ability to aid in the management (including the diversification) of both economic and financial risks. Modern finance plays this role by providing greater opportunities for the unbundling, repackaging, pricing, transferring, and ownership of financial and economic risks, once the original economic or financial transaction has occurred. In fact, the essence of finance is that it is a process of transforming the risks and uncertainties associated with human trust (counterparty risk) into other not necessarily easily measurable, marketable, and manageable components (such as market risk and liquidity risk). Likewise, one could conceive of a useful alternative definition along these same lines. That is, finance and the financial system can be seen primarily as a large and dynamic network of financial contracts facilitating a vast diversity of economic functions. It is worthwhile examining this function of finance in greater detail, because it encompasses an increasingly important and fundamental role of finance in advanced countries and mature markets.
Modern Essence of Finance: Pricing and Allocating Risk
The development of derivatives markets in the past several decades and their maturation in the late 1990s is perhaps the best example of the more fundamental risk-allocation function of finance, particularly in modern economic systems.21 For example, through the use of simple derivatives, such as interest-rate swaps, the financial risks inherent in a fixed-interest-rate loan can be easily transferred to another investor and swapped into a floating-interest-rate loan. Likewise, through the use of credit derivatives, the credit risk associated with a traditional loan can readily be swapped for another credit or insured; the loan could also be sold outright, perhaps through the securitization of the loan or a package of loans (known as asset-backed securities).
By allowing the unbundling and repackaging of risks, derivatives markets have helped transfer economic and financial risks to those most willing and capable of managing these risks. In so doing, finance in general, and derivatives in particular, can help individual economic agents diversify their portfolios of economic and financial risks. At the same time, finance—derivatives in particular—benefits the economy as a whole, in part by providing mechanisms and opportunities for spreading economic and financial risk-taking throughout the economy. It also provides alternative channels for financing the same economic activity. As risk-transfer processes become more highly developed and mature, they can help to protect economic agents and the economy and its financial mechanisms by providing diverse opportunities for risk sharing, and burden sharing, too, when adverse consequences actually occur in particular markets or in the economy as a whole.
The spreading of modern finance techniques within economies has been associated with a tendency to make financial markets more complete. As a set of markets becomes more complete, those markets provide greater opportunities for creating private insurance contracts against a greater number of economic and financial risks. For example, the development of asset-backed security markets has enabled individuals in many countries to obtain consumer loans and home mortgages, and students to obtain loans for education and job training. Before asset-backed markets were developed and reached a level of maturity, many economies could not provide these financial services and transfer these risks, either among economic agents or through time.
In developing, refining, and providing these new and modern techniques, the mature financial systems are finding new ways for economic systems to capture the full benefits of finance. They are doing so by finding more (and more precise) ways of pricing and managing the risks inherent in temporarily transferring to other agents the purchasing power of money, including the risk and uncertainty about the human trust element in every financial instrument and transaction. Modern finance has also made this human trust element in transactions more transparent, and in so doing has identified ways to minimize the uncertainty of human trust, for example, by being better able to price in the market risks associated with collateral that acts as a surrogate for trust in many financial transactions.
Finance, Fragility, and Evolving Social Arrangements
As has been suggested but not yet explicitly stated, fiat money provides the ultimate liquidity service. However, finance also introduces the possibility of leverage. In combination, the liquidity- and leverage-enhancing features of finance provide potential benefits and costs, the latter as a result of the potential creation of financial fragility. Throughout recorded history, societies have created social and institutional arrangements that have attempted to capture the benefits of finance and minimize the potential for fragility and other potential costs.
Liquidity, Leverage, and Fragility
In providing universally accepted means-of-payment services, fiat money embodies instantaneous purchasing power with the lowest risk possible.
Finance enhances the liquidity services of fiat money by creating instruments that simultaneously provide superior store-of-value services to one counterpart and access to liquidity to the other counterpart, both spatially and intertemporally. These instruments are primarily in the form of promissory notes whereby one person’s promise becomes another person’s potential liquidity, provided the promise is transferable (marketable) with relative ease. By so enhancing the liquidity services of fiat money, finance can facilitate and fuel a pace of economic activity far beyond what fiat money alone can support.
Although finance provides superior store-of-value services, its incremental additions to the pool of liquidity are less perfectly liquid than fiat money, because finance embodies counterparty uncertainty and risk.22 Taking a well understood example, traditional bank demand deposits are special forms of promissory notes that, by being widely accepted, are very close substitutes for fiat money. However, they are not universally accepted unconditionally in the way fiat money is. A bank’s promissory note provides liquidity to the economic and financial system, but it is less liquid than fiat money because it encompasses counterparty risk—this is, in part, why banking is a fragile business. Promissory notes issued by individuals are even more imperfect.
Consequently, there are both potential benefits and costs associated with finance. On the one hand, finance enhances the private and social benefits of fiat money, in part by enlarging the pool of liquidity available for production, consumption, and exchange, and in part by facilitating and enhancing the efficiency of economic processes. On the other hand, finance inherently embodies uncertainty—about fulfilling promises—and thereby changes the nature of the original pool of pure liquidity by bringing in instruments of less perfect liquidity and acceptability than fiat money. This introduces an element of uncertainty in individual private transactions, which has the potential for imposing costs (in terms of lost efficiency) for uninvolved third parties because of its potential adverse effects on liquidity. Thus, the inherent uncertainty in finance introduces a source of potential fragility and instability in financial markets that does not exist in most other markets in which tangible goods and services are traded. In this important respect finance is distinguishable from most other economic activities. Overall, the more positive features of finance provide efficiency enhancements and social benefits, while the more negative features entail the potential for instability and negative externalities (or contagion).
As a result, it is reasonable to see finance as encompassing both private and social trade-offs (and tensions). By embodying (and internalizing) uncertainty and risk about human trust tangible in intrinsically valueless instruments, finance enhances both private and social welfare. But by embodying a fragile human emotion like trust, finance is intrinsically fragile and, therefore, subject to instability under certain conditions. There are limits (albeit difficult to know and measure) to how far financial activity, liquidity, and leverage can be extended before too much finance is created on too little trust. When this situation is reached, imbalances tend to emerge and accumulate if left unchecked or if not self corrected.
Financial Institutions and Markets As Evolving Social Arrangements
As already suggested, the fundamental core of finance is the human promise to pay back fiat money to those willing to part with its services temporarily. The willingness of savers to do so involves a degree of trust that the promise will be honored.
In primitive or undeveloped economies, there tends to be significant uncertainty about whether promises will be kept, and limited enforceability of promises should they be broken (see Figure 2.1). Developed and modern societies have created social arrangements—such as social and business conventions and financial institutions and markets—in part to provide liquidity and pool risk and thereby to facilitate these intertemporal exchanges involving human promises and trust. These social innovations range from fundamental concepts of law and property rights, to institutional forums and structures that organize, process, and monitor information and pool risk taking. These forums run along a continuum roughly from individuals, to firms that provide intermediary services—or indirect finance, and extend to markets (both formal and informal) that allow individual lenders and borrowers to directly find matches of financial interests and comfort levels with uncertainty about human trust.
Figure 2.1.Evolution of Modern Finance
To consider this further, these social arrangements—in particular, financial institutions and markets—can be seen as society’s way of minimizing, or economizing on, the need for individuals to rely on human trust in finance (Shubik, 1999). That financial institutions accomplish this is now conventional wisdom, and can be understood most clearly by considering the franchise of a traditional bank. On the asset side of their balance sheets, banks specialize, and are perceived as having a comparative advantage, in gathering, processing, and monitoring information on those members of society that want to issue promissory notes in return for temporary access to and use of fiat money. Accordingly, banks own assets in the form of promissory notes issued by such individuals (and firms). In return, banks provide liquidity in the form of access to fiat money, usually in the form of a deposit. On the liability side of their balance sheets, banks issue their own special kind of promissory note—demand deposits or checking accounts—to those members of society who would temporarily lend their excess fiat money to others, but who have neither the time nor the expertise to enter into bilateral relationships with potential borrowers to assess human trustworthiness. By issuing demand deposits, banks offer individuals the opportunity to store purchasing power and wealth in the form of a relatively safe asset with some commensurate return for the risks they are taking, namely of trusting the bank to pool and invest funds wisely. In this way, banks pool the liquidity of depositors and make it available to others. This franchise allows banks to profit from matching savers and borrowers.23
The bank franchise is one of society’s arrangements for internalizing and pooling risk and uncertainty about human trust. In the absence of this pooling arrangement, uncertainty about trust would necessarily be embodied in bilateral promissory notes between individual savers and borrowers. By eliminating this need for finding a “double coincidence of wants” in exchanging promises for trust, financial intermediaries allow individuals the opportunity to avoid the costs of gathering information on the trustworthiness of those offering promises as stores of value. Banks likewise minimize the need for firms seeking finance to find that small subset of individuals possibly willing to enter into trust agreements.
Financial markets are another one of society’s arrangements for internalizing and pooling uncertainties about trust and they accomplish similar objectives in very different ways. Markets facilitate the direct matching of savers and borrowers in both formal, organized ways (exchanges, clearinghouses, and so on) and informal ways (or over-the-counter, bilateral transactions). These forums provide information to participants for judging individual creditworthiness, although the information may be different from that gathered by a bank.