In terms of public opinion, the past couple of years have not been kind to people who work in financial markets. The subprime mortgage meltdown and recession have generated negative feelings among a substantial number of Americans toward financial markets and the people who profit from them. Recent rhetoric in the Republican presidential primaries concerning Mitt Romney’s role at Bain Capital and Bain’s role in the economy has revived the issue.
Are financial markets a net benefit to society? Or are they an instrument for exploitation of one group of people for the benefit of another? To answer these questions we need to understand what exactly it is that financial markets do.
Financial markets exist to do a variety of things. One role they serve is to move wealth around over time. Very rarely is it best for a person to consume all of his income as soon as it is received. Financial markets facilitate delayed (or accelerated) consumption by allowing consumers to purchase financial assets today when they have a lot of income, and sell them later when their income level is low. In economics this is referred to as the consumption-smoothing motive, since it is driven by a desire to keep consumption constant over time, or at least to have it change gradually if it does change.
Middle-aged workers generally want to save because they realize they will have much lower income after they retire. Young and old consumers, on the other hand, often want to dissave. Young people may borrow when young to finance an education, for example. Retirees want to draw down their savings so they can continue to consume at a level close to what they did while working. This type of trade can be supported by relatively simple financial assets, like bank loans, or bonds.
Another role that these markets serve requires more sophisticated financial assets, however. That is the buying and selling of riskiness.
Some types of risk can be completely eliminated by appropriately diversifying. Auto insurance is a good example. The insurance company collects premiums from all its customers and makes payments equal to damages for those who have accidents. With a large number of customers the payouts over a given period of time can be predicted quite accurately. In the end all the customers end up mostly the same when it comes to their cars. They have all paid the premium and they all have a working car.
Some other types of risk cannot be eliminated by diversification. This type of risk is called aggregate risk. Even though it can’t be eliminated, it can be transferred. This is perhaps the most important role that financial markets serve.
Some people, like myself, are very averse to risk. They are often referred to as “hedgers”. They buy relatively large amounts of insurance and they take safe jobs at places like universities.
Other people, like my next-door neighbor, Brent, are less averse to risk. We call these people “speculators”. They tend to buy less insurance, or buy policies with larger deductibles, and they are more willing to take jobs that have greater income risk, like being self-employed.
Suppose I unexpectedly inherit an old abandoned gold mine from a rich relative. No one knows if the mine still has any gold in it. Suppose the mine has a 50-percent chance of being worthless and a 50-percent chance of generating a million dollars in profit. This is a risky asset. I don’t like risk.
My neighbor, Brent, doesn’t really like it either, but is more tolerant of risk. I could offer to sell the mine to Brent for $450,000. I would prefer have $450,000 for sure than the risky mine. Brent will end up with a net profit of $550,000 if the mine is viable and a net loss of $450,000 if it is not. As a result I end up with a much safer portfolio but lose an average of $50,000. Brent ends up with an average of $50,000 more than before, but his income is really risky.
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