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.

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https://www.core-econ.org/macroeconomics/06-financial-sector-12-financial-sector-overview.html#figure-6-19a

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.)

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https://www.core-econ.org/macroeconomics/06-financial-sector-12-financial-sector-overview.html#figure-6-19b

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.)

Advantages	Disadvantages
Debt allows people like Julia to consume before they have income (or, more generally, before they have enough income), or when their income is temporarily low.
Debt also allows borrowers like Julia (or companies) to invest in productive assets, including housing, thereby raising future output.
For Marco, debt has the advantage of providing a low-risk, or possibly zero-risk, future payment when he won’t have income.
Both currency and bank money are forms of debt that provide crucial services as a means of exchange.
Base money (currency and reserves) are both just government debt. They provide crucial services as a means of exchange and a unit of account.
Currency also provides the unit of account: the way we measure prices. The central bank’s use of monetary policy to stabilize the inflation rate helps to stabilize the unit of account.
Firms can use leverage to exploit the superior (but risky) return on productive assets, compared to the cost of borrowing. This in turn incentivizes them to find the most productive forms of capital.

Figure 6.20 The financial sector: what’s it all for?

Advantages	Disadvantages
Debt allows people like Julia to consume before they have income (or, more generally, before they have enough income), or when their income is temporarily low.
Debt also allows borrowers like Julia (or companies) to invest in productive assets, including housing, thereby raising future output.
For Marco, debt has the advantage of providing a low-risk, or possibly zero-risk, future payment when he won’t have income.
Both currency and bank money are forms of debt that provide crucial services as a means of exchange.
Base money (currency and reserves) are both just government debt. They provide crucial services as a means of exchange and a unit of account.
Currency also provides the unit of account: the way we measure prices. The central bank’s use of monetary policy to stabilize the inflation rate helps to stabilize the unit of account.
Firms can use leverage to exploit the superior (but risky) return on productive assets, compared to the cost of borrowing. This in turn incentivizes them to find the most productive forms of capital.

What is debt for?

The first column lists the advantages of debt. Fill in the second column with an associated disadvantage. (Some suggested answers are on the next slide.)

Advantages	Disadvantage
Debt allows people like Julia to consume before they have income (or, more generally, before they have enough income), or when their income is temporarily low.	Commitments to pay debt are fixed, so if Julia’s income turns out lower than expected, her consumption must fall, unless she defaults.
Debt also allows borrowers like Julia (or companies) to invest in productive assets, including housing, thereby raising future output.	As with borrowing for consumption, commitments to pay debt are fixed, while returns are risky, so debt makes the investment more risky (this issue is related to leverage).
For Marco, debt has the advantage of providing a low-risk, or possibly zero-risk, future payment when he won’t have income.	But he almost always faces at least some risk of default.
Both currency and bank money are forms of debt that provide crucial services as a means of exchange.	Using bank money as means of exchange requires current account deposits that can be withdrawn on demand. This creates potential for bank runs; government-sponsored deposit protection schemes aim to prevent these.
Base money (currency and reserves) are both just government debt. They provide crucial services as a means of exchange and a unit of account.	But the value of currency is eroded by inflation, so it is a very poor store of value. Governments may also be tempted to use base money as a means of financing deficits, leading to high or hyperinflation.
Currency also provides the unit of account: the way we measure prices. The central bank’s use of monetary policy to stabilize the inflation rate helps to stabilize the unit of account.	Central banks may not be given enough autonomy to maintain stable inflation, especially if governments wish to use base money as a means of financing deficits.
Firms can use leverage to exploit the superior (but risky) return on productive assets, compared to the cost of borrowing. This in turn incentivizes them to find the most productive forms of capital.	But there are significant associated risks: leverage makes the underlying return riskier. This is a particular problem with banks (discussed further in Unit 8), which have a strong incentive to increase leverage.

What is debt for? (Suggested answers)

Figure 6.20b

Advantages	Disadvantages
They can reduce the risk of lending on their assets (compared to bilateral debt) by diversification (and to some extent, by inspecting the quality of the loans).
They provide specialist lending to certain types of borrower (particularly households, particularly mortgages; also to small businesses).
Their liabilities (bank deposits, or bank money) are a store of value.
Banks provide the means of exchange. In many economies this form of means of exchange has increasingly replaced the use of currency.
Financial assets such as bonds and shares, traded in financial markets, allow households to invest indirectly in forms of productive capital that they would not be able to invest in directly.
From Marco’s perspective, he’d rather lend to a bank than to Julia, because the bank can spread the risk by diversification.

What are banks for?

The first column lists the advantages of banks. Fill in the second column with an associated disadvantage. (Some suggested answers are on the next slide.)

Advantages	Disadvantages
They can reduce the risk of lending on their assets (compared to bilateral debt) by diversification (and to some extent, by inspecting the quality of the loans).	But there is always some element of non-diversifiable risk, which must be borne either by shareholders or governments.
They provide specialist lending to certain types of borrower (particularly households, particularly mortgages; also to small businesses).	Increasingly commoditized via the internet.
Their liabilities (bank deposits, or bank money) are a store of value.	But they offer poor returns at long horizons due to inflation.
Banks provide the means of exchange. In many economies this form of means of exchange has increasingly replaced the use of currency.	Since bank deposits used for means of exchange can be withdrawn on demand, this introduces the risk of bank runs.
Financial assets such as bonds and shares, traded in financial markets, allow households to invest indirectly in forms of productive capital that they would not be able to invest in directly.	Returns on financial assets are often dominated by capital gains/losses, which can significantly increase risk, especially in the short term. Some economists argue that these price changes are driven by irrational factors, or bubbles.
From Marco’s perspective, he’d rather lend to a bank than to Julia, because the bank can spread the risk by diversification.	But there is always some element of non-diversifiable risk. Someone must bear this risk: either the shareholder of the bank or, if the bank fails, depositors may face losses. The government may also step in, so the taxpayer may end up bearing the risk.

What are banks for? (Suggested answers)

Figure 6.20d

Advantages	Disadvantages
Bond markets allow governments and corporations to borrow directly from investors.
Financial intermediaries are an important source of leverage for corporations.
Financial intermediaries are a source of leverage (indirectly) for households, since interest rates for long-term mortgages are to a great extent determined (via arbitrage) from bond markets.
Pension funds allow households to save for retirement during their working life, and can reduce risk by holding highly diversified portfolios of financial assets.
Returns on stock markets are risky, but are rewarded on average by higher returns, which are typically not affected by inflation rates.
Financial assets such as bonds and shares, traded in financial markets, allow households to invest indirectly in forms of productive capital that they would not be able to invest in directly.

What are financial markets and other financial intermediaries for?

The first column lists the advantages of financial markets and other financial intermediaries. Fill in the second column with an associated disadvantage. (Some suggested answers are on the next slide.)

Advantages	Disadvantages
Bond markets allow governments and corporations to borrow directly from investors.	Bond prices are very sensitive to changes in interest rates, resulting in risky returns over the short term.
Financial intermediaries are an important source of leverage for corporations.	Risk of default pushes up borrowing costs for risky borrowers, including governments.
Financial intermediaries are a source of leverage (indirectly) for households, since interest rates for long-term mortgages are to a great extent determined (via arbitrage) from bond markets.	Leverage has risks—the higher an entity’s leverage, the more its losses are magnified in bad times, just as the potential gains are magnified in good times.
Pension funds allow households to save for retirement during their working life, and can reduce risk by holding highly diversified portfolios of financial assets.	Most pension funds invest in risky assets. In ‘defined contribution’ pension funds, the household bears this risk. Other (‘defined benefit’) pension funds may make promises of guaranteed payments, while investing in risky assets, therefore with similar problems to banks.
Returns on stock markets are risky, but are rewarded on average by higher returns, which are typically not affected by inflation rates.	There is still significant non-diversifiable risk, from underlying productive assets, accentuated by leverage. Short-term fluctuations in stock prices can result in very significant reductions in wealth for those approaching retirement.
Financial assets such as bonds and shares, traded in financial markets, allow households to invest indirectly in forms of productive capital that they would not be able to invest in directly.	Returns on financial assets are often dominated by capital gains/losses, which can significantly increase risk, especially in the short term. Some economists argue that these price changes are driven by irrational factors, or bubbles.

What are financial markets and other financial intermediaries for? (Suggested answers)

Figure 6.20f

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?