MONEY and BANKING: ECON 3115 Fall 2011

Transcription

1 Professor Benjamin Russo MONEY and BANKING: ECON 3115 Fall uncc.edu Introduction and Chapter 1: Economics of Money, Banking and Financial Markets I) The Financial System and Economic Efficiency (this material is not covered in the text) 1) The Financial System is an extraordinary machine for increasing living standards. Yet the Financial System is the most regulated industry in modern economies. This course will cover the structure, social benefits and regulation of this extraordinary industry. 1 2) It will not be obvious to you now. but this is a case where it is useful to put the cart before the horse. So, here s the cart: The fundamental economic activity of the Financial System (FS, hereafter) is the transfer of funds from savers to borrowers with productive investment opportunities. This statement is descriptive: It does not indicate whether FS adds to the "efficiency" of the economy. In order to understand if, and how, FS contributes to economic efficiency, and whether or not economic policy can contribute to economic efficiency, we need the technical definition of efficiency. 3) The first thing to keep in mind is that economists often use different names for the same concept. E.G., economists use allocative efficiency, economic efficiency, Pareto efficiency, and just plain efficiency to refer to the same idea. The second thing to keep in mind is that the economic concept, efficiency, is only very weakly related to what non-economists mean by efficiency. Non-economists very often assume an economic activity is efficient if it is accomplished at the lowest cost. Lowest cost is not what economists mean by efficiency. That ain t what Adam Smith had in mind at all. So what did Smith have in mind? A) First, the simple, easy to remember, but somewhat ambiguous, description of economic efficiency. Then I will provide a more technical, and more precise, definition of efficiency. a) Simple definition of efficiency: Resources are allocated efficiently if, and only if, they are used where they provide the highest social value. Social value is determined by the value fully informed consumers and producers place on production and consumption. E.G., financial exchanges are efficient if, and only if, the Social Marginal Cost (SMC) of funds transfer equals their Social Marginal Benefit (SMB). So we say that FS is efficient if, and only if, SMC = SMB. To see why this is true, consider the following definitions and arguments: - SMB is the addition to total social benefits consumers receive from consuming one more unit of a commodity. It may sound corny, but it is easiest to think of benefits as subjective happiness, or utility, from consuming. E.G., if SMB of a power drink is 1.5, consumption of one more power drink increases the drinker's utility by 1.5 units. - SMC is the addition to total social cost of providing one more unit of a commodity. The correct way to measure social cost of a commodity is in units of other valuable stuff society must give up in order to have one more unit of the commodity. I.E., in economics social cost is measured in terms a commodity's opportunity cost. If SMC of a power drink is 3.0, its opportunity cost is 3.0 because society must forego 3.0 units of other valuable stuff to have one more power drink. 1 The Financial System is defined in Section III, below. 1

2 - The simple definition is satisfied if, and only if, SMB = SMC. Using food as an example, the argument for this condition goes like this: If SMB (of food consumption) > SMC (of food production), then increasing food production and consumption one unit increases total benefits more than it increases total costs: In this case, the social value of food production must increase. In contrast, if SMC > SMB, reducing food production and consumption one unit reduces total costs more than it reduces total benefits: In this case, again, the social value of food increases! Make sure you understand this. Therefore, resources are allocated where they have the highest social value if, and only if, SMB = SMC. - This condition is one of the most fundamental contributions of economic science. In the context of financial economics, FS maximizes social welfare if, and only if, the SMB of financial transactions equals the SMC. - The next definition of efficiency is more technical, yet provides a useful way of determining whether a change in government regulation moves markets closer to, or further away from, the allocation where SMB = SMC. b) Pareto efficiency: resources are used efficiently if, and only if, it is impossible to reallocate resources without making at least one person worse off. Note the implication: if it is possible to alter resource use, and thereby make a single person better off without making anyone else worse off, the allocation is inefficient. - Pareto efficiency seems like an impossibly high hurdle, so some perspective is needed. Pareto efficiency is concerned with net social benefits. If someone suffers an economic loss from a reallocation of resources, but that loss is exceeded by benefits to others, the gainers could compensate the losers, and still be better off. On net, the reallocation provides a social gain, so reallocating improves welfare and moves the use of resources closer to efficiency. - In the context of financial economics, if the net benefits of a government financial regulation are positive, then the regulation would move the system closer to efficiency. If the net benefits are negative the regulation would do social harm, and should not be implemented. 4) Does the FS efficiently transfer funds from savers to borrowers? The answer is yes, if the FS is perfectly competitive, and there are no financial externalities (defined below). If these two conditions hold, then FS directs funds to their most productive investment opportunities. Savers usually are not people with the best investment opportunities. E.G., probably not many retirees have practical ideas about the next great innovation in cellular phone technology. By transferring funds from savers who lack productive investment opportunities to borrowers with productive investment opportunities, FS increases economic value. In this case, everybody wins: savers earn a higher return than if their funds were not transferred to borrowers. Borrowers profit from investments they otherwise could not finance. And consumers end up with new and better products. 5) For unregulated funds transfer to be efficient, FS must be perfectly competitive. In financial economics, the crucial characteristic of perfect competition is perfect information. In general, this means that every economic agent knows the prices and qualities of all possible trading opportunities. In the context of financial economics, perfect information means that all parties to contracts know the risks and returns of financial transactions. 2

3 6) Why is perfect information so important? The answer is that under perfect information market prices potentially fully reflect social costs and benefits of production and consumption. In this case, prices effectively direct resources to where they have highest social value. 7) The word potentially in the last paragraph is emphasized because even under perfect competition, markets can fail to be efficient if production or consumption has external costs. 8) An external cost exists if the social cost of production or consumption exceeds the private cost. Consider air pollution. The private cost of electricity production does not include the health costs of air made unhealthy by burning fossil fuels. Damaged health is a real social cost. Because these social costs are not included in market prices, economic agents in unregulated electricity markets don t take them into account when making economic decisions (often, they don t know they exist). In this case, the people who benefit from electricity production don t pay the full social cost. Whenever people can benefit from a commodity without paying the full price, they tend to use too much. Production or consumption of a commodity is too high when SMC > SMB. This is inefficient: society is getting less than it paid for, resources are being wasted, and, most important, it is possible to increase social welfare by reducing production (see class notes for a graphical proof). 9) What does all this have to do with financial economics? Financial transactions can have external risks. If so, then information people have to make financial decisions is imperfect, and resources will tend to be mis-allocated. In this case, there is a potential that government regulation could improve the operation of the FS, and make it more efficient, or prevent it from becoming less efficient. E.G, according to Chairman Bernanke and former U.S. Treasury Secretary Paulson the private risks undertaken by individuals who ran the now-defunct investment bank Bear Stearns endangered the entire financial system. Bernanke and Paulson assumed that the social risks of letting Bear Stearns go bankrupt were so large they had the potential to wreck the entire financial system (and take the economy with it). Bernanke and Paulson based their regulatory decisions on this assumption, and arranged a bailout of Bear Stearns (the Fed guaranteed Bear Sterns liabilities taken over by Morgan Stanley). In economic terms, Bernanke and Paulson acted as if they believed their interventions in the financial system avoided greater inefficiency. II) Why do Money and Banking Courses Cover Money? Note that one major goal of most central banks is control of the general level of prices, and inflation. There was a time when central banks attempted to control inflation by setting, or targeting, the money supply. Money targeting did not work well, so central banks no longer target money. Then why do Money and Banking courses cover money? Why not just skip this topic? We cover money because monetary exchange adds to economic efficiency. In general, financial instruments, markets, and institutions increase efficiency by: 1) lowering financial transactions costs, 2) reducing and/or spreading financial risk, and 3) matching financial preferences. Money accomplishes all three of these, so using money in exchange is efficient. To see this, note: 1) Jumping ahead to Chapter 3 (Mishkin, page 54) for a moment, barter exchange requires a Double Coincidence of Wants. That is, in a barter economy in order to make a commodity exchange you must locate someone who has what you wish to buy, and who wants to buy what you have to sell. This takes time, so it is costly. But in monetary exchange everyone is willing to take money in exchange, so a double coincidence of wants is unnecessary. Therefore, monetary exchange has lower transactions costs and is more efficient. 3

4 2) Liquidity (Mishkin, page 29) refers to the ease and speed with which an asset is converted into cash. The more liquid an asset is, the safer it is because it is easier for the owner to sell the asset to reduce or avoid capital losses. Money is more liquid than other assets, so money is less risky than other assets. The less risky assets are, the more willing are economic agents to trade and invest, which increases production of commodities people value, which is efficient. 3) In a barter economy, it is exceedingly hard for people who prefer liquidity (people who are risk averse) to satisfy that preference. Money is the most liquid asset, so in a monetary economy, this preference is easier to satisfy, which is efficient. III) What is a Financial System (FS), and How is it Related to Economic Efficiency? What is FS? The FS is comprised of two categories of financial institutions: 1) financial intermediaries and 2) financial markets. Bank of America is an example of a financial intermediary more on financial intermediaries in Chapter 2. The New York Stock Exchange is an example of a financial market. What is the economic function of the FS? The efficient transfer of funds from those with excess funds (savers) to those with a deficiency of funds (borrowers). What is meant by efficient transfer of funds? Funds transfer is efficient if the funds are transferred to borrowers with the most productive investment opportunities. In this case: i) financial resources are allocated where they have the highest social value; and ii) it is impossible to reallocate resources without making at least one person worse off. How does the FS contribute to the efficient transfer of funds? The FS can reduce the cost of funds transfer by taking advantage of economies of scale and scope. The financial system can direct funds to their most efficient uses by reducing asymmetric information (for definitions, see the Glossary in Mishkin s text. We ll come back to these issues later in the course). Why should anyone care? Efficient funds transfer contributes to long-run growth in living standards. How does the FS contribute to long-run economic growth? By: 1) lowering transactions costs, 2) reducing and spreading risk, 3) matching preferences 4

5 IV) Can Financial Regulation Increase Efficiency? 1) The answer depends on the structure and characteristics of the FS. If the system is perfectly competitive and financial transactions have no externalities, unregulated market are efficient (This is the economic argument for free markets). But what, in the context of financial economics, is perfect competition and what are externalities? 2) For the FS, the most important features of perfect competition are rationality and perfect information: A) Economic agents are rational if they use all available financial information to maximize their own self-interest. More precisely, economic agents are rational if the use financial information up to the point where the SMC of information equals its SMB. B) Perfect information occurs if, and only if, each agent in a contract has full information about the contract s risk and return. 3) If external costs exist, part of the cost of production and consumption is imposed on people who do not benefit from the exchange. If external benefits exist, then production and consumption are not maximizing economic (social) value. Both conditions are inefficient. E.G.: If the creation of financial products produces financial toxic waste that sickens the financial health of people who do not benefit from the products, market rates of return do not reflect all the social costs of financial services. In this case, risk premia are lower than the efficient amount. If imperfect information exists in financial contracts, unscrupulous borrowers and lenders can hide risk, which will not be reflected in rates of return, which is inefficient. 4) In the cases mentioned in the last paragraph, government regulation has potential to improve economic welfare. Too often, however, that potential is unrealized. Regulation s potential to improve welfare is attainable only if it causes prices to adjust so that they reflect all social costs of production and consumption of financial services. 5