Unit 6 The financial sector: Debt, money, and financial markets
6.3 Debt and the financial sector: Financial intermediaries and financial markets
- capital goods, capital
- Capital goods (sometimes shortened to ‘capital’) are the durable and costly non-labour inputs used in production (e.g. machinery, equipment, buildings). They do not include some essential inputs (e.g. air, water, knowledge) that are used in production at zero cost to the user.
The bilateral debt contract between Marco and Julia and their grain balance sheet may seem a world away from the modern financial sector. But it does bring out some key features of the role of debt in an actual economy, which we shall explore later in this unit. A first step towards describing the financial system is to introduce the key actors and markets. For households and businesses, these play an important part in the practicalities of investing, and moving consumption over time; and enable them to acquire assets that they could not buy outright. For households, a place to live—a house or apartment—is the prime example; for businesses it is the purchase of capital goods.
Financial intermediaries and financial markets
The financial sector consists of organizations that provide financial services, and markets where financial assets are bought and sold.
- financial intermediary
- An economic agent, such as a bank or pension fund, that borrows from savers and simultaneously lends to borrowers. Intermediation provides an alternative to bilateral loan contracts as a way of channelling savings from people who want to lend to those who want to borrow.
- bond
- A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
- shares, stocks
- Shares (also known as stocks) are financial assets that can be bought and sold, giving their owners (the shareholders) shared ownership of the assets of a firm, and therefore a right to receive a corresponding share of the firm’s profit.
- bond market
- A financial market in which people buy and sell bonds that have been issued by governments or companies. See also: bond.
- stock market
- A financial market in which people buy and sell shares (stocks) in companies. See also: shares, stocks.
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Financial intermediaries simultaneously borrow and lend, and typically make profits from channelling savings between savers and the ultimate users of their savings. In particular, we shall explore the role of banks, and how this relates to the various things we call ‘money’. But there are many other types of financial intermediary. Most notably, pension funds allow households to save and invest in financial assets over the course of their life cycles.
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In financial markets, large borrowers, especially large companies and governments, trade directly with investors (who are often, like pension funds or insurance companies, acting on behalf of households). Companies and governments are able to borrow directly by selling liabilities called bonds. Companies can also raise funds by selling shares in the ownership of the company (also known as stocks and equities—the terms are interchangeable). Once issued, bonds and shares are actively traded in bond markets and stock markets—where the holder of a bond or share can sell it to someone else. This is called secondary trading.
Bonds and shares
Bonds and shares are types of financial assets.
- maturity
- The maturity of a debt—such as a bond, or mortgage—is the date at which the loan must be fully repaid.
Bonds are issued by companies or governments when they want to borrow funds—typically to finance investment. The initial purchaser of the bond pays an initial amount (for example, $100) to the bond issuer in exchange for a promise that the issuer will pay a specified dollar amount (for example, $5), called a coupon, at regular intervals over a given period (such as 30 years). At the end of the period, the bond matures; the issuer will make the final coupon payment and repay the initial amount (referred to as the principal, here $100). Since the initial purchaser of the bond can, if they wish, sell the bond at any point in the secondary market, the payments of coupon and the repayment of principal will be made to whomever owns the bond at that time.
Companies can also raise funds by issuing shares. A share is a unit of ownership of the company: for example, if a company initially issues 5,000 shares at $2 each and you buy 50, you will be a shareholder who owns 1% of whatever the company owns. Unlike a bondholder, you will not receive regular payments on your investment of $100, but you will receive a 1% share of any dividends the company pays out, and can (in principle) participate in company decisions by voting at shareholders’ meetings.
- commodity markets
- Markets in which natural resources (such as oil, or silver) and agricultural products (such as wheat, coffee, or cotton) are bought and sold, typically in large quantities by institutional investors and producers.
Commodity markets, which trade things from oil to metals to pork bellies, are also closely linked to financial markets, and the two share many similarities.
- real estate
- A general term that covers three types of property: land, housing, and other buildings.
- liquidity, liquid, illiquid
- An asset is described as liquid if it can easily be sold (exchanged for money). Savings at a commercial bank are highly liquid if you can instantly withdraw them in cash, but less so if you have to give notice to the bank several weeks or months before a withdrawal. Housing is a relatively illiquid asset (that is, not liquid): it can take months or even years to complete the sale of a house.
There are important similarities and linkages between financial markets and real estate (in particular, housing) markets. The difference is that, while financial assets are typically liquid (you can sell a share or a bond in a matter of seconds), real estate is relatively illiquid (it can take months to sell a house).
The financial sector: Some evidence
The total value of all outstanding liabilities (all the debts owed by someone to someone else) provides an indication of the size of the financial sector. In the United States, this was $220 trillion at the end of 2022: about 8½ times GDP.
GDP grows over time, but in the last 75 years debt has grown much faster. Figure 6.5 shows the marked upward trend of the ratio of liabilities to GDP in the US; in contrast there has been no clear trend in the ratio of wealth (the aggregate net worth of US residents) to GDP.
Figure 6.5 Total liabilities and wealth: multiples of GDP.
This was a period of significant growth in living standards: US GDP per capita was almost four times higher in 2022 than in 1951.
Richer countries typically have larger financial sectors and liabilities relative to their income. Figure 6.6 shows that there is a quite strong correlation across countries between the extent to which people in different countries participate in financial markets, and the level of GDP per capita.
The left-hand panel provides one measure of participation in the financial sector by comparing the proportion of households in each country that have some form of debt (liabilities) with the country’s GDP per capita. Households in richer countries are more likely to have some form of debt. In the two lowest-income countries in the sample, Greece and Slovakia (middle-income countries by global standards), only around a third of households have any debt but in the richest country, the United States, the proportion is roughly three-quarters.
Figure 6.6 The relationship between participation in the financial sector and GDP per capita, showing lines of best fit.
Note: This figure uses standard ISO country codes to label the countries.
The right-hand panel suggests that there is also a positive relationship between GDP per capita and participation in stock markets, measured by the proportion of households that own at least some shares, either directly or indirectly (for example, via pension funds). But only around half of US households own any shares, and in Greece and Slovakia less than 10% do so.
While the evidence highlights the recent expansion of activity in the financial sector, and suggests an association with living standards, it does not tell us how it affects economic outcomes. In this unit, we build on the insights from our model of bilateral debt in Section 6.2, and explore the economic rationale for the financial sector more generally, and its role in the macroeconomy. In Unit 8, we explore how the massive build-up of debt contributed to the global financial crisis of 2007–2009.
Question 6.4 Choose the correct answer(s)
Read the following statements about debt and the financial sector and choose the correct option(s).
- Financial intermediaries both borrow and lend.
- Bonds are a way for firms and governments to borrow directly by selling their liabilities in financial markets.
- It can take months to sell a house, whereas it only takes a few seconds to sell a share or bond.
- The opposite is true—the percentage of households that have some form of debt is positively related to a country’s GDP per capita.
Question 6.5 Choose the correct answer(s)
Read the following statements about Figure 6.5 and choose the correct option(s). (Note that US GDP grew, in both real and nominal terms, over the time period shown.)
- There is no clear trend in wealth (as a multiple of GDP) but because GDP rose over this period, wealth must have risen roughly in line with GDP.
- Wealth as a multiple of GDP remained constant over this period.
- Debt as a multiple of GDP was stable but, because GDP increased over this period, the absolute amount of debt must have increased as well.
- Debt as a multiple of GDP was stable, while wealth as a multiple of GDP has increased.
