The financial system performs several important functions in modern economies, without which existing businesses would find it difficult to expand and new businesses would find it hard to get started. That means that economies would struggle to grow, which means lower living standards for people. In short, we all benefit when the financial system works.
The financial sector facilitates the growth of businesses by moving resources to where they can best be used. You can think of it as a bridge, connecting savers who have spare resources, with borrowers who need more resources than they currently have. When savers put their money in the bank, when they buy bonds, or when they buy stock, the financial sector trucks that money across the bridge so that investors can fund their investments. This funding enables folks to invest—in a college education, a family home, or launching or expanding their business—when they wouldn’t otherwise be able to pay for those investments up front.
Another way to think about this is that the financial sector is a time machine that can move your money through time. This is particularly important for investments that involve a big up-front cost today that’ll generate ample returns in the future. The financial sector makes it possible to spend money today that you’ll only earn in the future. It effectively gives you the means to zap money from the future to the present—by borrowing from a bank, issuing stock, or issuing bonds. Alternatively, if you want to zap money from the present into the future, you just need to deposit that money in the bank, or alternatively put it in stocks or bonds. Then, in the future, when you need that money, you can make a bank withdrawal or sell those stocks or bonds. Voila! Your money just traveled through time to meet Future You. And hopefully it grew a bit along the way.
The financial sector does more than move money around, it also plays a protective role, reallocating, spreading, and diversifying risks. Putting your money in one big investment or loan is risky because if that investment fails, you’ll lose your life savings. The financial sector helps people avoid this by slicing risk into smaller pieces that can then be bought and sold. It means that you can buy a small amount of many different stocks and a small amount of bonds issued by many different companies, and your bank will lend your savings to many different borrowers. The result is that you’ll hold a diversified portfolio, which is a lot less risky than one big bet. As people buy and sell these risks, they will be reallocated to those best positioned to bear it. The result of all this diversification and reallocation is that each of us faces less risk, which means you can sleep easier, knowing your savings will still be there tomorrow.
The financial sector also creates liquidity, which means that you can quickly and easily convert your investments into cash, with little or no loss in value. As a partial owner of Nike, you’ll always have easy access to your money because you can easily sell your stock on the stock market. Likewise, buying a 10-year bond doesn’t commit your money for 10 years because you can sell that bond on the bond market. And it’s easy to turn your bank balance into cash, simply by going to the ATM to make a withdrawal. All of this liquidity is a good thing: It means that you can make long-term investments, but if something comes up and you end up needing your money, you’ll still be able to access it.
Yet the usefulness of financial markets comes with a warning. The financial sector illustrates the interdependence principle, and all this interdependence can make the economy more vulnerable to financial shocks. The value of a stock or a bond depends on what other people are willing to pay for it, which depends on what they think others are willing to pay for it. This raises the possibility of speculative bubbles, which can burst savagely, destabilizing the economy. When your money is used to fund other financial investments that can be used to fund other financial investments, a chain of interdependence is created, which can cause one bad investment to have ripple effects. If no one knows which other financial institutions are exposed to those losses, then these ripple effects can create a wave of fear as no one knows whose money is safe.
The point is that even though the financial sector does a lot to make the economy work better—reallocating resources from savers to investors, shifting money through time, spreading and reducing risk, and creating liquidity—it also makes the economy more vulnerable to manias, panics, and crashes.