Unit 6 The financial sector: Debt, money, and financial markets
6.12 The financial sector: A summary and overview
We earn income in some periods of our lives but not others. To smooth income over the life cycle, so that we can consume during periods of education, unemployment, and retirement, we need to be able to borrow and save. Secondly, since our incomes come from working with productive assets (capital goods and land), we all rely on investment in productive assets.
The role of the financial sector in the economy is to make borrowing, saving, and investing possible—or at least, more efficient and effective than it would otherwise be.
Financial markets and intermediaries: A visual summary
The financial sector—banks, other financial intermediaries, and financial markets—provides the foundations for debt and money, both crucial to a modern economy, and allows households to invest (often via financial intermediaries) in a much wider range of productive (but risky) assets than they would be able to invest in directly.
Figure 6.19a captures all the key linkages we have discussed in this unit. It incorporates the primary financial intermediaries that were omitted from Figure 6.13.
The diagram is still a radical simplification of the linkages within the financial sector. It omits, for example, commodity markets. Banks in particular trade extensively in commodities and other specialized financial assets.
Figure 6.19a A summary of the financial sector, with both markets and financial intermediaries. Solid red arrows represent ownership of productive assets, dashed blue arrows show flows of investments made directly by the party involved, and purple dotted arrows indicate flows of investments made through financial intermediaries.
The diagram illustrates how the financial sector relates to the rest of the economy. But it is also useful to remember that, in a closed economy, and hence in the world as a whole, debt must cancel out in aggregate because for every debt (liability), there is a matching financial asset. Recall also that shares simply represent a claim to (share of) the net worth or equity of a company and that households are the ultimate owners of companies. Combining these insights means that, for the economy as a whole, the financial sector simply disappears.
Figure 6.19b summarizes the ownership of wealth in the aggregate economy. National wealth—made up of the productive assets of land and capital goods—is owned by the households and the government. (Remember, though, the wealth is very unequally distributed; many households have very few such assets.)
Figure 6.19b The financial sector disappears: all wealth is ultimately owned by households and the government.
While some of the benefits of the financial sector are clear, the financial sector is a subject on which economists often disagree. Some economists point to the benefits of debt for consumption smoothing, diversification, and efficient use of savings, and argue that fluctuations in the prices of assets in financial markets convey signals that increase the efficiency of the economy. Such economists typically argue for ‘light-touch’ regulation of the financial sector. Others point to the frequent recurrence of financial and debt crises, and the extent to which the financial sector reinforces existing wealth inequality. They argue that financial markets are prone to self-reinforcing bubbles, while attracting a substantial fraction of a society’s talent to this sector, exploiting skills and capacities that could productively be employed in other sectors. This group of economists argue that without substantial regulation, financial systems are unstable and subject to costly booms and busts (as discussed further in Unit 8).
Exercise 6.12 The financial sector: What’s it all for?
The key elements and contributions of the financial sector are summarized in Figure 6.20.
The slideline contains three tables, each with some advantages of the financial sector already listed in the first column. Use the information in this unit to fill the second column with the associated disadvantages. (Some suggestions for each table are in the following slide.)
Exercise 6.13 So how do you live if you don’t work?
Kwame and Sophia, who live in the world we observe, both expect to spend roughly half their lives not working. Julia and Marco, who inhabit the model world of this unit, face the same problem, in particularly extreme forms.
We learned that wealth, as a store of value, enables consumption to be shifted from one period of someone’s life to another. The period over which this transfer takes place can be as short as a few hours (most people earn their income during working hours, but do most of their consumption out of those hours) to multiple decades. We also learned that, at an aggregate level, wealth only consists of productive assets. These are intrinsically risky, but the evidence suggests that this risk is rewarded with higher returns.
- Think about the key periods of your life when you consumed goods and services but did not work, and think about what such periods might be like in the future. In light of the material covered in this unit, what are the mechanisms that enable this to happen?
- This unit showed that the financial sector and debt can play a crucial role; but the examples of Sophia and Kwame in Section 6.1 showed that this role is complemented in crucial ways by both families and the state. Which of these dominates in your own country? How do they complement each other? How do you think the system could work better?