Why we need financial markets

“My true adversary in this battle,” he said “has no name, no face, no party… it is the world of finance.”

Thus spoke new French President Francois Hollande while campaigning last month. Despite the seeming backwardness of such sentiments, it is no secret that many people actually do feel a degree of animosity toward the world of finance and financial markets (indeed, Francois won the election). The popular media often furthers such sentiments, lampooning financial markets as “irrational” or “volatile”.

Financial markets have several economizing features, however, that help to overcome the limitations inherent in saving and investing that arise in the absence of financial institutions.  As we shall see, financial markets confer social benefits by extending the division of knowledge (really an extension of the division of labor), shifting capital into the hands of those most capable of investing it, helping reduce uncertainty inherent in human action which is future-oriented, and provide liquidity to investors who possess shorter time horizons.

Financial markets improve the division of knowledge in society by bringing savers and investors together who would not otherwise know about each other.  Information is not uniform among all individuals.  Someone who has low time preference, and has saved accordingly thus has capital to invest.  However, in an international economy, this saver may be ignorant of many investment opportunities.

Likewise, investors who may be aware of certain profitable opportunities may not have personally engaged in capital accumulation through saving. Financial markets allow for the linkage of those with resources to invest and those with knowledge about profitably investable opportunities.

Additionally, those individuals with low time preferences and large pools of savings may not be the same individuals who have superior entrepreneurial foresight. Thus, financial markets couple the saved resources of individuals with low time preferences with investors who have superior investment skills. Closely related is the fact that different individuals have different temperaments more or less suited to bearing uncertainty.

In short, those who save may not have the skills either through foresight or risk-taking capabilities to execute particular investments.  Thus, financial markets allow the division of labor to be extended as individuals align with their comparative advantage.

Next, financial markets help us deal with the uncertainty that is inherent in investable projects (note that all human action is speculative because the future is uncertain). Ceteris paribus, individuals prefer less risk than more risk for a given return.  In order to understand how financial markets pool risk, we must first distinguish between risk and uncertainty, alternately termed “class probability” and “case probability” respectively. Risk or class probability refers to the fact that in certain circumstances, we know everything about a class of events, but we do not know anything about individual events except whether or not they are members of a particular class.

Insurance is the typical financial market that helps to dilute this type of risk, and it does so through a probability density function that can be known through empirical evidence. Like-minded individuals can pool their resources to insure against catastrophic destruction such as a tornado, for instance. No one middle-class individual could insure himself against a tornado because the asset of his house is more than his yearly salary. Thus, with insurance markets that deal in class probability, risk has been diluted over a large group of people instead of one person bearing it individually.

Lastly, financial markets provide greater liquidity to individuals who desire it, and in so doing, allow for investment in projects with a wider variety of time horizons until completion. Without financial markets, only individuals with extremely low time preferences would be able to make any loans at all. If there is no secondary market in which to sell the claim to the loan, the lender is essentially “stuck” into the time horizon of the investment project.

The same holds true for equity.  If individuals had to hold equity for a twenty year time horizon, few people would buy it. It becomes efficient, however, for businesses to fund thirty (or longer) year projects via bond financing as long as there is market for these bonds to be traded.  Because there is no necessary time horizon congruence between savers and investors, financial markets allow for long term projects to be financed through the buying and selling of claims to bonds and equities. This makes a saver more likely to buy in to long-term investments.

By bringing together savers and investors, shifting investable capital into the right hands, pooling risk, and allowing for long-term projects, financial markets exert positive influences on the growth of the real economy.

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  1. Why we need financial markets (Francois Hollande is wrong) « Economics Info - June 23, 2012

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