Last week I introduced financial assets, and pointed out that purchasing these assets is in fact a way to save. Most assets actually represent a form of credit to a company. Typically, a dealer extends the credit by buying the asset and then sells it on in financial markets. Hence, assets “intermediate” between savers and borrowers: by buying an asset a saver lends his savings to a company that needs credit.
My post on credit emphasised its importance to the economy, and in a later post I suggested that: “Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.” In this context, it should be clear why I feel it is so important to understand financial markets.
Economics textbooks have a tendency to oversimplify, and suggest that financial markets channel savings towards investment. For example, Mankiw’s best-selling ‘Principles of Economics’ states:
“The demand for loanable funds comes from households and firms who wish to borrow to make investments… investment is the source of demand for loanable funds.” (Third edition, page 571, emphasis in original.)
Where the purchase of an asset does fund investment, we have an excellent system that intermediates between savers and investors, ensuring that savings are put to productive use. Where assets are sold for the purpose of funding investment, there is no paradox of thrift, because the spending on investment ensures that the money continues to circulate around the economy.
But guess what – the picture is as not as straightforward as the textbooks paint! First of all, the sale of financial assets is also use to fund consumer credit. At least in this case there is no paradox of thrift – the savings are being recirculated back into the economy. If the economy has the capacity to meet demand, this credit will enable the economy to be more productive, so is performing a useful function. But the flow of credit into particular sectors (e.g. housing) can also cause inflation if the economy cannot meet the increase in demand.
And sometimes (often), someone will sell an asset because they want to buy a different kind of asset (different level of risk, different yield, different maturity). But that means that someone else now has the proceeds from selling an asset, so the question shifts to them – will they now spend these proceeds in the real economy? This could actually build into a chain of asset buying and selling. At some point, someone selling an asset will then spend the money back into the economy, but that this does not necessarily happen quickly, and this delay will also cause the paradox of thrift. Think of it this way – if money is circulating around in financial markets, with people buying and selling these assets to each other, that money is not circulating around the economy for goods and services (known as the real economy, because it’s the market for real things).
Wealthy individuals and businesses tend to save a greater proportion of income (and they will save by purchasing financial assets, not by leaving it in a savings account). So if the functioning of the economy tends to channel an ever greater proportion of business profits into the hands of the most wealthy, we will see an increase in money circulating around in financial markets. And this means that this money is not circulating around the real economy – it is draining out and causing the paradox of thrift. This is an example of the conclusion I emphasised in my last post on Saving (part 3):
“The distribution of wealth is critical to the future path of the economy.”
An increase in demand for financial assets needs to be met by an increase in the supply of assets, or it will cause asset price inflation (think bubble). It’s great if you happen to retire at the peak of a bubble, but not so great if you retire just after a crash – the value of your pension fund might just have been halved.
This is an oversimplified overview – to properly explain these dynamics of financial markets needs a bit more detail and will be the subject of a series of posts in the future. The key point here is that the “fundamental value” of a financial asset is determined by the future profitability of the associated business, which in turn is determined in part by its productivity. If asset prices are driven up by increasing demand, and if the credit is not being channelled towards investment, the value of these assets will become inflated. At some point prices will fall, and savers discover that their savings are not worth what they thought.
And what this highlights, once again, is that the value of saving – whether it contributes to national saving, an increase in the wealth of a nation as a whole – depends on how those savings are used. Is it stimulating demand in sectors of the economy with spare productive capacity? Is it funding investment? Is it funding investment in sectors of the economy with good long-run prospects, providing the goods and services that we will most need in the future? We can only save as a nation through investment, and financial markets do not necessarily channel savings towards investment, regardless of what the textbooks say.
Financial assets intermediate between savers and borrowers, and this is a vital function in the economy. But attention needs to be paid to what this credit is being used for. Financial markets are huge, and economists, politicians and journalists simply haven’t been paying enough attention to them. Indeed, they reduced significantly the amount of oversight and regulation, assuming that it works best if just left to the free market. After the financial crash they discovered this amazing market-based credit system and termed it “shadow banking”. It’s a somewhat demeaning term – it wasn’t really in the shadows, it’s just that they weren’t looking in the right place because the mainstream economic theories were not pointing them in the right direction.
We will look at this important area of economic life, the market-based credit system. When we do we will learn a lot about how the economy works in reality, but we need to cover a few other areas first. So just to help you think about this in concrete terms, next week I’m going to explain how commercial paper works. Not many people will have heard of this (outside of financial circles) and you won’t read about it in economics textbooks, but it’s an extremely important asset that ensures a flow of needed credit to businesses. The commercial paper market is generating about a trillion dollars of credit in the US alone at time of writing. It’s one of the many types of assets available that intermediates between “savers” and those needing credit, and looking at how it works in reality will help you grasp the concept of financial assets before we finally move on.
And next week’s post will end this whole series of posts, over 13 weeks, that have used used models to look at the fundamental concepts. Finally, we will be ready to move on, and look at how the flow of money, including banking, really operates in the real world.