Part I Foundations

Garry Schinasi
Published Date:
December 2005
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As noted in Chapter 1, despite some professional consensus about why financial stability is an important policy objective and intellectual progress in analyzing certain financial-stability issues, the existing literature does not provide a cohesive framework. Moreover, within the financial-stability policy community, no fully articulated and widely accepted logical foundation yet exists that joins the elements of the consensus into a cohesive, consistent, and comprehensive whole. The articulation of such a logic could help identify where intellectual differences lie, and help establish a foundation on which to build a financial-stability framework.

The chapters in Part I develop such a logic—drawing ideas from and synthesizing important elements of disparate economic and finance literatures. One important conclusion of the analysis, and a lesson for the many less developed financial systems around the world, is that an effective (if not efficient) process of finance requires extensive private-collective and public policy involvement, to internalize and capture social economic benefits and public goods associated with finance. While much of this may be well understood and taken for granted in financial-system policymaking in mature, advanced-country financial systems, it is neither widely understood nor accepted more broadly.

Logic of the Arguments

Because the arguments of Part I are drawn from several literatures, a preview of the logic of the arguments is useful.

In modern economies, fiat money (legal tender) provides ultimate liquidity in the form of finality of payment; it also has the important quality of anonymity. A dollar bill is accepted in the United States irrespective of who is exchanging it, just as a euro coin is accepted in much of Europe and a yen coin in Japan. Together, liquidity and anonymity make fiat money society’s surrogate for trust in trade and exchange. Used as a store of value, fiat money is imperfect and less unique, because its effectiveness depends on the ability of a small group of public servants (working in a monetary authority or central bank) to design and execute policies to maintain its value. Thus, an element of uncertainty surrounds the durability of the value of money.

Throughout recorded history—and even before the introduction of monies of various forms—societies have created and used alternative stores of value. Broadly construed, this is finance: a process, comprising private contracts and social arrangements (laws, institutions, codes of conduct, governance), that produces and exchanges stores of value. More specifically, finance creates instruments of no intrinsic value that enable private counterparts to temporarily transfer the finality-of-payment services of some form of money to others in exchange for a promise to reverse the transfer later, either for equal or greater value or to share in some reward (profit) in the future. Accordingly, finance embodies uncertainty about human trust and is closely tied to the characteristics, value, and dynamics of money.

Even though finance can be seen primarily as a dynamic network of private contracts, arrangements, and transactions, it provides both private and social benefits. It does so by enhancing and redistributing the characteristics and services of money, including as a public good. In so doing, finance facilitates and enhances opportunities for intertemporal economic processes and ultimately social prosperity. More specifically, it facilitates several economic processes: a greater amount of trade and exchange, production, savings, and investment; a more efficient allocation of resources; greater and more effective opportunities for wealth accumulation and economic development and growth; and greater opportunities and effectiveness in unbundling, repackaging, pricing, and trading financial and economic risks.

However, there are both private and social downside risks associated with certain aspects of finance. When the veracity of promises to pay comes to be doubted, uncertainty and risk tend to rise: financial counterparts reassess, reallocate, and reprice uncertainty about trust. This process usually occurs in an orderly fashion; but often enough it does not. In a worse-case scenario, widespread uncertainty about trust in finance leads to panic and a dramatic rise in the demand for society’s surrogate for trust—some form of money as legal tender—until trust and confidence are restored. Because of the links between finance, money, intertemporal economic processes, and uncertainty about trust, when financial stability is called into question, monetary stability—and economic stability more generally—will also be at risk.


The topics of Part I are organized as follows:

Chapter 2 reviews important aspects of finance as a process of allocating and pricing resources and risks and how this process relates to real economic processes. The first section examines the relationship between finance and fiat money, organized around the conventional services of money, and identifies several important and unique aspects of finance. It asserts that finance intrinsically involves uncertainty about human trust—the source of both its strengths (facilitates economic processes and efficiency) and weaknesses (inherently includes the potential for market imperfections and fragility).

Building on these important characteristics, the second section of Chapter 2 discusses the enormous economic benefits provided by an effective process of finance. These benefits originate in the ways finance improves economic efficiency and, more specifically, facilitates important economic processes such as resource and risk allocation, wealth accumulation, growth, and social prosperity.

The third section of Chapter 2 examines characteristics of finance that can temporarily reduce private and social benefits, or worse, create the potential for financial and economic instability. It also briefly discusses some of the social arrangements that have evolved to deal with this potential fragility.

Chapter 3 frames the public policy aspects of finance described in Chapter 2. The first section applies the economics of the public sector to finance. In addition to the usual sources of inefficiency in finance—such as asymmetric information and incomplete markets—this section argues that widespread access to an effective process of finance is associated with significant positive externalities and that finance has the characteristics of a public good.

The second section of Chapter 3 discusses some of the main public policy implications of the fact that finance is a public good. One of these implications is that achieving the full private and net social benefits of finance requires maintaining a delicate balance of private-collective and public policy involvement in the main constituent parts of finance (infrastructure, institutions, and markets). In some countries, greater reliance on market discipline may be required, while in others a greater reliance on government involvement might be needed. A second implication is that achieving these objectives also requires a balance between maximizing the social benefits (associated with positive externalities and public goods) and minimizing the social costs (of the other sources of market imperfections). In countries with undeveloped markets this balance might be achieved through a greater emphasis on building the constituent parts of finance that create the positive externalities and public goods, while in the more advanced markets attaining this balance may require greater emphasis on warding off the adverse consequences of other sources of market imperfections.

Chapter 4 briefly illustrates, with some simple supply and demand graphs, the distinction between inefficiency and instability, drawing on the sources of market imperfections.

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