The Essential Role and Ubiquity of Finance

The Essential Role and Ubiquity of Finance?

Economic events can be understood as allocation of consumption, finance and production inputs across agents like households, financial institutions, governments and the producers. Economic history of nations (at any point of time) can be understood as the sequence of a date-event pairs that reflects a social mechanism for allocating resources over space and time. The fundamental driving forces of such an allocation mechanism are the heterogeneity of individual circumstances like differences in preferences, endowments, information, technology, and social capital across individuals over time and space and motives for maximizing wealth accumulation and lifetime consumption. Taken together, all this implies a need for resource transfer across space as well time. Trade across time is essentially a contract involving the future resource flows in exchange for current and past resource flows. The theory of finance or financial economics studies this phenomenon and further refines it in a behavioural context. Finance itself is a discipline that studies the allocation of economic resources under uncertainty (This uncertainty can be symmetric in the sense that neither the borrower nor the lender knows whether price of the commodity that the borrower sells will rise or crash in tomorrow’s market (leading to different abilities to repay the same debt) or it may be that the borrower knows the risk element better than the lender.) whether at the individual level, at the level of a particular market or at the societal level as a whole. The role of finance in this sequence called economic history is called weakly essential if, there is some minimal heterogeneity among individuals across time that leads to atleast one type of financial asset traded at all dates and having positive value. Clearly, very little heterogeneity is required to satisfy the essentiality of finance, posed in this way. In fact real world data would show much more variations in individual circumstances than that and would at every date generate many types of financial assets being traded, which leads to finance being strongly essential. Indeed when we look at the history of economic transactions, except those of the most primitive barter societies, there was always an element of contract for the future. And if we start from the ancient times of city-states, we certainly see the unbroken sequence of various types of contracts that are financial in nature.

There are different dynamic or inter-temporal decisions in the economy involving dynamic social welfare maximizing by governments subject to ex ante resource constraints, maximizing expected utility by individuals subject to ex ante and ex post budget constraints, maximizing expected profit of exporters from commodity trade with limited time to execute their contracts and value maximization of production by firms with time to sell. In all these decisions, financial assets appear in the budget constraint at every date where the budget constraints cannot be consolidated due to transaction costs like strategic motives for not trading, lack of trust and information, uncertainty and ex ante unforeseen contingencies in incomplete markets. Thus financial asset markets and spot markets for goods and labour are interlinked over the cross section and time. Governments facing borrowing constraints cannot raise resources using first best methods for stabilizing the economy. Borrowing constraints faced by entrepreneurs limit their possibility to produce and expand. Producers facing liquidity or working capital constraints can employ and sustain only a limited amount of labour. Households facing borrowing constraints cannot afford the desired quality of education to children. Thus “incomplete markets” prevents consolidation of budget constraints and imposes limits on “the wealth of nations”. In the monetary, fiscal and regulatory analysis in a subsequent chapter, I shall show why markets are “incomplete” The ramifications are discussed in different parts of the book.

Incomplete markets lead to financial market imperfections due to transaction costs and “information under uncertainty”. These lead to strategic portfolio management, strategic trading of financial assets and strategic negotiations of financial aspects of contracts which affect the budget constraints of decision makers at every date. The economy is thus characterized by wealth accumulation through portfolio management, financial asset trading and financial contracting by strategic individuals and institutions. Those institutions and individuals having adequately large amount of financial assets use their asset profile to generate more financial resources through strategic trading or borrowing. Economic growth generated surplus is usually used to overcome fixed costs of human capital acquisition and starting business by individuals and for financial innovation, diversification and monitoring by financial institutions. This increases the rate of return on different kinds of capital which reinforces the growth process. The net result is excessive financial asset hunger due to increasing returns in the finance linked growth process. Increasing returns in wealth accumulation process leads to liquidity constraints and debt constraints being exacerbated in financial markets. An individual with limited financial assets finds that money can give enhanced opportunities of income generation and consumption over her relevant time horizon but at the same time finds that she has limited access to financial resources despite other individuals and institutions sitting on plenty of idle money. Thus she falls in the increasing returns induced “financial asset trap”. At other times characterized by optimism in retail lending by financial institutions, the financial system induces her into falling in “debt traps”. Both phenomena increase economic inequality during the growth process of the economy. For all these reasons, it is more appropriate to refer to economic dynamics as financial system dynamics. This causes the growth sequence to be peculiarly unfair and maladaptive to plans made by governments. Robust mal-distribution of wealth, income and liquidity gets generated in an unbounded manner and precipitate social unrest. Possible positive externality effects of fiscal interventions get twisted into liquidity misallocation for an adequately unpleasant length of time. Some long shut markets open to restore parity but can do so only partially. Welfare improving coordination failures are speculated by some to be some kind of complementary mechanism to policy interventions. However, distributive injustice cannot be solved by instability and remarkable policy lessons are lying in the ruins of these experiments. I argue in this book, that the learning process from the unpleasant dynamics is of importance though. Nothing happens without the blessings of providence. Therefore, this controversial dynamics needs to be seen from different angles.

The first reason for analyzing financial system dynamics is that money plays an essential role and has positive value. This is because dynamic economies involve inter-temporal resource transfers like property transfer, goods transfer, renting and leasing, lending and borrowing and savings and investment, all of which needs a cash in advance or a deferred unit of payment acting as a medium of exchange and store of value while providing the socially useful role as an unit of account. This is the essential role of time in generating a demand for money in dynamic economies. But why is money demanded when other assets can be held which give higher return? There are three main reasons: the inconvenience of barter, possible illiquidity of other assets in a dynamic economy, and the fact that money is a relatively safe asset than others. Money as a debt of the sovereign or the asset of the merchant is the standard medium of exchange due to problems of barter and gift system under transaction costs, search costs, and information costs. One needs to understand trade in space-time continuum to appreciate how money replaces barter. Barter and money may coexist but it is a complex theory and I shall return to it later. More important is the theory of merchant and his trade. This generates a sequence of contracts and brings profitability wherever there are gains from trade. Economic growth results if most merchants achieve success in this way and more money is found in the system to accommodate the growth process. Wherever growth path is approximately stable, the government does not intervene but wherever the growth path is unstable, the economic plans are kept a little bounded by tight monetary policy. If a more sophisticated liquidity sequence and asset pricing process leads to financial fragility in advanced economies and sovereign debt crises in less developed economies, then the international financial system needs to sort out the mess through bringing backup rules, rigidities and compromises. More unpleasant financial system dynamics cannot be found anywhere in history and it is difficult to imagine an international risk sharing plan which can be implemented simultaneously in different economies without being compromised. This is the cost of living in a complex financial world. In the days of barter, time was slow and people were optimistic. The world of money is a different kettle of fish altogether as all agree. But we need money when time requires us to do so. And we need complementary and supporting institutions like banking and financial markets. Of course, an integrated analysis of money, banking and finance is needed to appreciate how much advancement in welfare these institutions have brought about. Due to structural reasons, some development processes have been thwarted from time to time. As a result, Pareto improving welfare programs have been lying idle in shelves of different governments. But in the limit, when all reasonable plans and expectations get cancelled, new markets open randomly. Modern monetarists have invented the concept of liquidity. It cannot be understood without a perspective on general equilibrium theory. Illiquid markets paradigm is isomorphic to the incomplete markets setup. Let markets open with individuals owning bonds indexed by date-event pairs and with some real endowments. Let us suppose that markets, atleast upto a point of time, are incomplete in the sense that all events for each date-event pair are not covered, or in other words there are less bonds than would make it a perfectly state contingent world. At any date-event let us suppose that a person has more endowment than he desires to consume and therefore becomes a net seller of commodity at that date. Let there be another person at the same date-event who has less endowment than she desires to consume and therefore becomes a net buyer at that date.? Without loss of generality, let it be the case that the buyer finds that at that date-event pair she has no bond or security that can be accepted for transaction. Therefore she needs a liquid asset for the spot transaction at that date where that asset would be accepted by the other party. Such a liquid asset will be accepted under the condition that it would help the other party (seller) in a similar difficulty at a future date where he will be a buyer and will not have any liquid bond to finance a purchase. In other words then, the liquid asset becomes money or a medium of exchange with positive value since the date it was created because of the essential role it plays in the drama. Money is a safe asset as long as inflation is bounded within a fairly medium range. Volatility of prices of other assets is much greater and therefore a risky asset is demanded only if adequate monetary cushion is there. Banks play a crucial role in keeping money safe.

The second reason for studying financial system dynamics is to understand the role of finance in facilitating inter-temporal trade and capital accumulation. Finance studies the allocation of resources under uncertainty where some agents in the economy contract to acquire finance from others subject to certain conditions of repayment. This allows production that takes time and in particular investment in capital goods which leads capital accumulation. The analysis can be in a bilateral setting, partial equilibrium setting or a general equilibrium setting. The subject becomes interesting due to the element of uncertainty regarding future repayment due to various kinds of transaction costs. This uncertainty affects the inter-temporal allocation of resources apart from the intra-temporal allocation. Thus a proper study of the subject of Finance involves asking questions on the dynamic allocation of resources under different kinds of transaction costs pertaining to the issue of incentives and ability for repayment of promised obligations over time. There are different types of strategic financial contracts and markets but all of them are subject to the essential question on the inter-temporal character of debts and possibilities future repayments.

The third reason for studying financial system dynamics is to understand costs and benefits of dynamic portfolio management and dynamic trading in financial markets and financial innovations in general equilibrium under transaction costs and complex risks. In dynamic economies, different kinds of contractual innovations are needed in order to optimize the efficiency of production, facilitate trade and smooth consumption paths. Risk taking for high growth activities need to be protected by risk sharing arrangements and capital cushioning. Stability in the small and large contexts needs to be addressed through provision of reserves and stabilizing instruments. Inequality in different forms needs to be anticipated and tackled by risk sharing contracts which may be completely financial or also complemented by social risk sharing devices or political alliances for lobbying over resources. There are many impediments to forging such contracts like cost of getting together and search for the ideal contractual partner, bargaining costs over the terms of the contracts under different imperfections (like incomplete information, behavioural inconsistencies), costs of commitment, costs of information acquisition, cost of credible information transfers, costs of contract drafting and understanding costs, costs of verifying to courts and so on. So first, we need to understand such contracts from the perspective of transaction cost economics. Debt contracts exist due to verification costs, commitment costs, signalling costs and costs of transfer of control. Equity contracts exist because of costs of risks which need sharing, costs of issuing debt like bankruptcy costs, costs of not sharing control rights etc. Rental contracts are partially financial due to cost of monitoring, enforcement costs, eviction costs etc. Employment contracts are financial because of structural properties of the economy and contractual incompleteness and limited participation. Public debt and taxation are part of the financial system because of the need for government expenditure for stabilization, growth and equitable transfer system. Apart from these normal functions in public finance, there are also additional contingent functions like strategies for resource mobilization during war, post-war reconstruction and for maintaining peace through expenditure on various items externally and internally.?

In dynamic economies, contractual structures, profits, incomes of different segments of society are generally changing due to real as well as financial reasons and changes manifest in forms of real as well as financial changes. The causes are not well understood. In this book I shall characterize a paradigm where these causes-consequences chains can be understood better. This will lead us to a better discussion about positive and normative analysis. This will lead to a more refined understanding of dynamic efficiency in a complex world and shed new light on dynamic efficiency, stability and distributive fairness.