Edition 52, Finance

The Financial Market and the Economic System: Some Thoughts on Theory and Practice

By: Jorge O. Moreno
Instituto Tecnológico Autónomo de México

Introduction

It is common among students, some specialists and fortunately fewer researchers in the academics to make a distinction in the approaches of the professions of economists and financiers regarding the scope of their respective disciplines.

Traditionally, economists focus on analyzing the “real sector” of an economic system (divided into markets, specific industries, or in the macroeconomic aggregates such as production, inflation and employment), while financiers are interested in studying the “financial sector” and offering solutions for phenomena associated with these markets (represented by the movements and fluctuations in prices and returns of financial instruments and derivatives, or by the decisions of the financing structure of the companies).

Notwithstanding the interrelation of the two disciplines and the complementarity of the theoretical foundations of their models and methods, the complex problems facing contemporary society (poverty, inequality and vulnerability, among others) and the methods proposed to solve these social challenges require the mutual understanding of these two fields. This mutual understanding becomes crucial for characterizing the functioning of an economic and financial system that is based on the allocation of resources through a pricing system, and for designing viable public policies that consider the difficulties of each problem and each possible solution.

This article offers some thoughts about the strong linkage between economic theory and finance, and about how the mutual understanding of these two disciplines provides a context for complex problems. Examples include the growing need of having a strong financial system with wide coverage and services, as well as some implications of the recent financial reform as seen from the perspective of the economic incentives that it aims to change.

Supply, demand, equilibrium and optimality

Whenever I have the chance, particularly at the beginning of a course, I like to ask my students these three questions to motivate my lectures. First: what is traded in the market for tomatoes? Usually they answer right away, and while laughing, they say: “Tomatoes.” The next question is a bit more difficult: What is traded in the labor market? After a bit more reflection, and based on the human capital theory of economist such as T.W. Schultz and Gary S. Becker, a consensus is reached: the unit of trade in a labor market is “work,” which is a bundle of specific skills associated with a service and whose market price is a collection of values represented by a salary that summarizes the yield of various attributes such as education, experience and non-cognitive skills.

Nonetheless, the third question is a challenge even for advanced students: What is traded in the financial market? Frequents answers include “money,” “securities,” “services”, and “derivatives.” The truth is that defining this concept is essential for understanding all the topics that are studied in finance and which are strongly linked to the real economic system. The good that is traded in a financial market is liquidity, coordinated by the supply and the demand of financial instruments of individuals, households, businesses and the government itself. Each financial instrument, ranging from cash to more complex derivative instruments, provides financial flows that become liquidity for their holders. Therefore, behind the source of value of each instrument, simple or complex as it may be, is the liquidity that it can provide to its buyers and sellers.

The financial market allows the investors the coordination between their needs for liquidity among investment in terms of timing and insurance. These portfolios allow investors plan future cash flow and serves as the catalyst for the key component of what contemporary macroeconomic theories call the “consumption and permanent income hypothesis.” In other words, financial instruments allow the smoothing of consumption patterns over time, and the efficient allocation of risk through optimal savings and investment.

An investor reaches this optimal allocation of resources by selecting income profiles; aiming to reach a desirable level of consumption for each eventuality; this profile of cash flows provide stability and security for consumption and can be duplicated and defined in portfolios that combine securities. In such a case, the investor’s portfolios encompass simple savings, insurance contracts, investment in more complex financial market instruments, such as mutual funds, the stock market, or derivatives or even unconventional but commonly used methods, such as a group savings pool in the case of households lacking access to formal savings markets.

These liquidity needs, backed up by the organization of investor’s different portfolios, determines the supply and demand and are organized through financial intermediaries (banks, insurance companies, brokerage houses, bonding companies, mutual funds, etc.). As these intermediaries provide information and bear the costs of coordinating supply and demand, they earn a profit derived through attaining a “market clearing” and balancing the two economic driving forces of liquidity provided by each of the financial instruments.

At this point, upon analyzing the aggregate equilibrium that must exist in an economic system that coordinates liquidity using the financial system, economic theory and financial theory reach a point of agreement on two important results: the Euler’s Equation of Consumption, regarding the real economy, and the Fundamental Asset Pricing Equation, in the case of finances.

Euler’s Equation of Consumption (see the references to classic macroeconomics, such as Barro (1992), Lucas (2002), and Sargent and Ljungqvist (2003), among others) establishes that in the optimal case for decisions by an investor, it must be true that the subjective marginal value present consumption and of consumption linked to a probable future situation is reachable in time. This relative value is matched from period to period conditioned on the agent’s information set , while taking into account the uncertainty of given any distribution of events with and the investor’s impatience for delaying his present consumption from the present to the future :

(1)

Also, when the savings and investments needed to achieve the liquidity profiles required by an investor are done through a financial market, that is buying and selling financial instruments at a spot price , and given that these instruments offer future cash flows that face a potential uncertainty , the Fundamental Asset Pricing Equation of financial market establishes that the spot price reflects the discounted value of those future cash flows, considering a certain discount factor that future liquidity flow brings to present value :

(2)

In this case, the set of discount factors defines the essential content a sort of “genetic” marker of value formation in any financial asset, and it is called “pricing kernel” or also “state price vector,” as it is linked to the cost that theoretically arises from transferring today’s income to a uncertain future. This set of values has a property applicable to all the assets, and given the set of information under uncertainty , it expected value must be centered precisely around the risk-free ratio, that means, the average discount is precisely the risk free rate of the economy:

(2)

While the link between both equations is not trivial, given the set of assumptions and bases of both theories, particularly the postulates on rational investors who always look for the highest level of wealth, full and competitive markets, symmetrical information among agents, and without additional transaction costs, both equations are symmetrical images, and they are the solution to the same problem.2

_________________________________________

2 Strictly speaking, the theoretical equivalent between both equations is the existence of theoretical financial instruments called arrow securities, which have a price on the spot market and allow investors to buy units for future income for each possible contingency.

This means that if the goal is to understand the dynamics of the prices of a financial instrument, knowing the properties that support the creation of derivative instruments, planning the creation of an investment profile, characterizing the capital structure of a new business, or evaluating a project using the “present net value” criterion – then behind all of these models there is a financial system that coordinates supply and demand, and all these financial results are a summary of the equilibrium and simultaneous interaction of all the investors.

In addition, it is interesting to note that the major traditional models of economic growth are based on the key assumption of a financial system that is perfectly coordinated and whose functions are irrelevant, since in these models the financial market does not create value, it just coordinates it, as postulated by the famous theorem of Modigliani and Miller when analyzing external financing of businesses (see Freixas and Roche, chapters 1 and 2, for a clear explanation on the topic).

In the following two sections two cases are presented in which the use of microfoundations of equilibrium, prices and quantities presents a better view of the problems of the financial system.

Size does matter: The reach and depth of the financial system

When we study the size of the financial system, our goal is to measure its “liquidity provision” it provides. There are many traditional and accepted measures, such as the size of private credit in relation to the gross domestic product, or the number of ATM cashiers per 1,000 users for instance. However, these metrics are insufficient when we want to understand if a financial market meets its functions of providing liquidity to all the investment agents and potential investors in an economy.

In recent studies in Mexico regarding the credit market (Moreno, 2014) and the market of automated teller machines (Moreno and Zamarripa, 2013), there are two measures that stand out in order to understand the size and importance of the services that are offered in the financial market: The first metric deals with the reach of the system, the potential number of clients or users with access to a financial service; the second addresses the depth of the system, defined as the number and size of the transactions carried out by each user of the financial system.

By analyzing these metrics it is understood that the interaction of real economy and the financial system presents not just economies of scale (a larger size favors a reduction in supply costs), but also economies of reach (financial intermediaries use the same platforms to offer differentiated products, including diversifying their levels of risk) and network economies externalities (this is the degree of acceptance of a certain financial product or service that is crucial to its success or disappearance.

How does one determine the prices for a financial service that manifests particular conditions such as those just mentioned? The answer is complex. If costs are decreasing, should a high price be charged for a certain period until acceptance is achieved? When comparing costs and benefits, should access or depth be encouraged? Who should provide access: the traditional financial intermediaries such as banks and insurers, or should it be different intermediaries with specific functions such as microcredit institutions?

The use of automated bank tellers (ATMs) serves as an example of how complex a liquidity service within the financial system can be. In a recent book, Moreno and Zamarripa (2013) show that in Mexico the costs of an out-of-network bank teller (a fee known as a surcharge) affect the totality of resources that are assigned and exercised by users through the ATM network, and, in this way, it affectsthe depth of services and harms the users of small networks that face high costs.

What policy should be followed to establish the right price for the use of the tellers? The answer contains many difficulties that one must consider, but above all, this policy must focus on the benefit of widening access and use of the network. This way, the price of the service contains an external component for use of the network; that is to say, high fixed costs initially for installation, but relatively low marginal costs for operation. That should lead to a series of regulations that induce a price that encourages the use of shared ATMs, an efficient use of the teller network, and, given the trend to provide more complex financial services, such as the payment of services and taxes, a complete banking experience that differs from the traditional aim in which teller machines simply deliver cash to their clients.

Financial regulation: expansionist or prudent

A second example of the importance of understanding the interrelation between economic and financial theories is represented by the regulation that is recommended for the financial system, particularly for banks.

Recent studies (Moreno, 2014; Sánchez and Zamarripa, 2014) have shown that in Mexico the levels of supply liquidity through credit are very small compared to many international standards.

The need for credit to promote investment in small and medium businesses was a key part of the policy goals that gave shape to the administration’s 2014 financial reform that sought to solve that problem.

However, Moreno and Zamarripa (2014) show that this reform presents goals found in its economic and financial theoretical base, and that its instrumentation may not be altogether successful as there are opposing goals, such as the expansionist policies for credit levels, and prudential policies for risk regulation, which restrict the capitalization levels of the financial intermediaries.

In other words, the logic of supply and demand states that the expansion of credit would be destined for clients outside of the financial system whose cost of risk management can be, on average, relatively greater than that of clients who already have credit. These costs can raise the average interest rates for banks when contracts of greater risk are presented than those contracts already assigned. Therefore, they increase the risk exposure in the bank’s credit portfolios.

This way, knowledge of the incentives for placement of credit in terms of risk allows us to conclude that a greater level of credit represents a benefit for new productive projects, but also a cost upon adjusting the risk levels of the bank’s credit portfolios.

Conclusions

The financial market is cause and effect of the production system: They reflect the same essential reality of the economy within which they operate. Supply and demand for liquidity, as well as incentives of their operation, affords knowledge of the mechanisms through which the prices and services of a financial market are determined.

Each price simultaneously reflects the equilibrium, the agent’s incentives, the uncertainty, and the information available to investors in an economic system. All the models of financial valuation are based on this basic principle of rationality and equilibrium known as the “hypothesis of efficient markets,” which was proposed by Nobel Prize winner Eugene Fama. It says that prices of financial instruments reflect the current value of the liquidity flows they provide, integrating all the available information.

Similarly, the results of efficiency and social welfare in an economic system that is based on a pricing system and on a capitalist model require a financial system that efficiently supplies the services and products needed by the investment agents and potential investors.

Understanding the financial models as a result of a rational economic process allows identification of costs, benefits and challenges of any decision-maker in finance, but also the incentives, distortions and results that can be expected from applying regulations and public policies designed to modify the financial system in one of its dimensions to favor consumers and investors.

Bibliography

  • Barro, Robert. 1990. Macroeconomics. McGraw- Hill.
  • Freixas Xavier, y Jean-Charles Rochet. 2008. Microeconomics of Banking. MIT Press.
  • Lucas, Robert. 2002. Lectures on Economic Growth. Harvard.
  • Moreno, Jorge O. 2011. “Heterogeneity, Matching, and the Hedonic Structure of the Credit Market”. Feb 11, 004-11-FINM-TP, ITAM School of Business.
  • Moreno, Jorge O., y Guillermo Zamarripa. 2014. “Análisis de la reforma financiera en México”. FUNDEF research document 2014-003.
  • Moreno, Jorge O., y Guillermo Zamarripa. 2013. Redes de cajeros automáticos en México: Un análisis de transaccionalidad. FUNDEF, México.
  • Sánchez, Jorge, y Guillermo Zamarripa. 2014. “Análisis del crédito en México. FUNDEF research document 2014-002.
  • Sargent, Thomas y Lars Ljungqvist. 2010. Recursive Macroeconomic Theory. MIT Press.

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