I got to thinking about this because of Nick Rowe’s question - Does the "industry" of Finance actually *create* short, safe, liquid, simple assets out of long, risky, illiquid, complex assets (in the same way that the steel industry creates steel out of iron ore). Or does it just redistribute those properties so that the people most/least willing to hold assets of a particular length, safety, liquidity, complexity get to hold most/least of what they want?
In other words, does finance fit into this mold of an economic enterprise that takes inputs and turn them into outputs.
In a way, yes. But likening it to the steel industry does not really give us a fully accurate view. And you need to model finance properly if you want to be able to analyze its effects on the overall economy.
I’m pretty sure that even if you ask finance insiders, they will find it very difficult, if not practically impossible, to pigeonhole it with a comparable category in the real economy. To illustrate my point, here are several ways that finance is different from enterprises that turn inputs into outputs. But to make it fun, let’s continue with the steelmaker analogy.
1. So the steelmaker turns iron ore into steel, but no supplier will actually demand to get back his iron ore, and no one is going to destroy steel just to return someone's iron ore.
2. In this finance aka steel company, its buyers do not buy the steel for the utility they get from it. They buy it as a store of value, but more importantly, they buy it with the full intention of selling it again, and with the expectation that they will sell it a higher price than they bought it for.
Now here is where it gets interesting…..
3. Profits that buyers make from selling higher priced steel can go into buying more steel, an activity which in itself makes the price of steel go higher.
4. Because the price of steel is getting higher, more buyers are lured to buy it, again with the expectation of selling it to the market at some point, always at a higher price than they bought it for.
5. But as more steel is bought, and the higher its price, the more steel is being made, to sell to even more buyers who want to unload it to still more buyers.
6. Because the intent of all steel buyers is to sell to other buyers, nobody wants to be the last one buying steel. This sentiment in itself should ensure that at some point the price of steel will stabilize, and in fact start going down.
7. So all buyers are now fully preoccupied with trying to outwit everybody. Because the steel market will crash once buyers start thinking it is now selling at the peak price, no existing holder wants to be seen selling steel. One way that sellers do this discreetly is to pool steel with rubber tires, plates, hand fans, or what have you, and sell the entire thing as a bundle (Hey, maybe tires, plates and hand fans are still being expected to go up in price).
8. As a consequence, when the shit hits the fan, buyers who thought they were buying hand fans are surprised to find themselves holding steel.
9. Because of this dynamic, the steelmakers are rewarded not for making the best steel, but for managing to sell the most steel, even when every other buyer wants to be sellers themselves.
10. Because buyers caught holding steel need to make up for their loss (maybe they borrowed to finance the purchase) they unload whatever they can. This means hand fans, rubber tires, plates….their prices also hit the fan (not the figurative hand fan).
So where am I going with this? I really don’t know. I have yet to find the appropriate analogy. I told you, once you try to abstract finance with the intention of understanding how it works, you end up getting lost in endless thought streams that somehow melt into each another. So now pls. excuse me, I think I just poked my eye with my pencil.