Chapter 9: The Financial System, Economic Performance, and Information Asymmetry

The Financial System and Economic Performance

  • The Foundation of Economic Growth: Many economists believe that a strong financial system is a necessary foundation for a country to experience robust economic growth.

  • Defining Economic Growth: High economic growth refers to the process of increasing the standard of living for citizens.

  • Mathematical Representation of Standard of Living: The standard of living is calculated as:     Standard of Living=GDPPopulation\text{Standard of Living} = \frac{\text{GDP}}{\text{Population}}

  • Historical Perspective on Living Standards (United States):     * In the year 1900, the GDP per capita in the U.S. was $5,000\$5,000.     * By the year 2022, the GDP per capita rose to $70,000\$70,000.     * This represents a 14×14 \times increase in the standard of living over approximately one century.

  • Drivers of Increased Standards of Living:     * The primary reason for the 14×14 \times increase is the significant rise in labor productivity.     * Labor has become more productive over time due to three key factors:         1. Increases in Capital: More tools and machinery per worker.         2. Increases in Education: Better-trained and more knowledgeable workers.         3. Increases in Technology: Innovations that allow for more efficient production.

  • Policy Implications for Future Growth: To increase productivity to thresholds like $100,000\$100,000 or $120,000\$120,000 in the next 100 years, further investments in capital, education, and technology are required.

The Financial System, Savings, and Investment

  • The Savings-Investment Identity: The financial system facilitates the identity where savings in an economy equals investment (S=IS = I).

  • The Market for Loanable Funds Graph:     * The Price of Funds: Represented by the interest rate on the vertical axis.     * The Quantity of Funds: Represented on the horizontal axis.     * Money Demand Curve (Demand for Funds): This curve represents firms and businesses that wish to tap resources to invest in their companies and expand productive capacity.     * Money Supply Curve (Supply of Funds): This curve is made up of savers, primarily comprised of households and the government.

  • Equilibrium in the Funds Market: The equilibrium interest rate and the quantity of money available exemplify the identity that the amount of dollars available in the funds market is equal to the amount of savings done in the economy and the amount of investment available.

  • Facilitating Transfers: A strong financial system is required to facilitate the transfer of savings from households to businesses to be used as investment. This undergirds a higher standard of living.

  • Consequences of an Undeveloped Financial System: In countries without a functioning market for funds—due to a lack of savings, a non-existent supply curve, or a non-existent demand curve—increasing the standard of living is extremely difficult. A poor financial system and a high standard of living cannot coexist.

Problems Facing Small Investors

  • Inefficiencies in the Modern Financial System: Despite its importance, the financial system does not always work efficiently. Small investors (often called "mom and pops") face specific hurdles.

  • Transaction Costs:     * Definition: The costs associated with a trade or a financial transaction.     * Example: Making a purchase through a brokerage firm (like Fidelity or E*TRADE) often incurs a commission or service fee for buying or selling a financial asset.

  • Information Costs:     * Definition: These are the costs that savers incur to determine the creditworthiness of borrowers and to monitor how funds are used.

  • Impact on Small Investors: Because small investors lack the resources to gather comprehensive information on creditworthiness, they face higher information costs. While some platforms allow users to bypass specific fees, the volatility of markets like the S&P 500 still poses risks.

  • The Efficiency Gap: Existence of transaction and information costs means:     * Savers receive lower returns on their investments.     * Borrowers must pay more for the funds they borrow.     * The overall efficiency of the financial system is reduced.

  • Opportunities for Profit: If a firm can find a way to reduce these transaction and information costs, they can increase profitability and capture the potential gains from these efficiencies.

Economies of Scale and the Trend Toward Large Institutions

  • Role of Financial Intermediaries: Banks and mutual funds reduce transaction costs while maintaining returns for clients using the microeconomic concept of economies of scale.

  • Definition of Economies of Scale: The reduction in average costs that results from an increase in the volume of goods and services produced. As a bank gets larger, costs per unit decline.

  • Mechanisms of Cost Reduction:     * Standardized Legal Contracts: Banks make many loans and use standard contracts. The cost of writing these contracts is spread over many loans, reducing the cost per loan.     * Specialization and Division of Labor: Rather than one person performing five tasks for a single loan, a bank hires five specialists to perform one specific task each. This specialization increases volume and lowers per-unit costs.

  • The "Too Big to Fail" Paradigm:     * The drive for efficiency leads banks to become massive conglomerates.     * Bank of America: Employs approximately 130,000130,000 people. In places like Raleigh, North Carolina, it is essentially a "company town."     * The Bailout Problem: This growth leads to the problem of institutions becoming "Too Big to Fail" (TBTF). When these large institutions fail, the government feels compelled to bail them out using public funds.

  • Case Study: Silicon Valley Bank (SVB):     * Though not as large as Chase, Bank of America, Wells Fargo, or Citi (it was roughly the 14th or 16th largest), it was still deemed significant enough for a government intervention.     * The government ensured deposits were intact even beyond the FDIC limit.     * Critical Perspective: This dynamic leads to profits being privatized (shared with shareholders) while losses are subsidized (paid by the public/John Q. Public).

Asymmetric Information: Adverse Selection and Moral Hazard

  • Definition of Asymmetric Information: A situation in which one party to an economic transaction has better information than the other party.

  • Hypothetical Screening/Asymmetry Example: A company selling bonds might know they are near bankruptcy, but bond buyers lack this information.

  • Analogy: "Margin Call" (Movie): Illustrates a firm selling valueless mortgage-backed securities on Monday morning through a "fire sale" to counterparties who lack information about the securities' true lack of value.

Adverse Selection

  • Definition: The problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment.

  • The Used Car Market ("Lemons") Example:     * Potential buyers cannot distinguish between a "good car" and a "lemon" (a bad car).     * Assume a buyer values a good car at $20,000\$20,000 and a lemon at $12,000\$12,000.     * Research indicates 75%75\% of cars are good and 25%25\% are lemons.     * Calculating Expected Value (EV):         EV=(Probability Good×Value if Good)+(Probability Bad×Value if Bad)\text{EV} = (\text{Probability Good} \times \text{Value if Good}) + (\text{Probability Bad} \times \text{Value if Bad})         EV=(0.75×$20,000)+(0.25×$12,000)\text{EV} = (0.75 \times \$20,000) + (0.25 \times \$12,000)         EV=$15,000+$3,000=$18,000\text{EV} = \$15,000 + \$3,000 = \$18,000     * The Problem: The buyer offers the EV of $18,000\$18,000. However, the seller knows the car's true quality.         * A seller of a good car refuses $18,000\$18,000 because it is $2,000\$2,000 below value.         * A seller of a lemon happily accepts $18,000\$18,000 because it is $6,000\$6,000 above value.     * Result: Good cars are withdrawn from the market, leaving only lemons. The market has "adversely selected" the products remaining for sale.

  • Mitigation of Adverse Selection:     * Intermediaries/Dealers: Act as quality gatekeepers to protect their reputations (e.g., Yelp or Google Reviews).     * Information Services: Companies like CARFAX, Moody’s, or Dun & Bradstreet provide data to reduce information costs.     * Collateral: Lenders require borrowers to pledge assets as a good faith effort.     * High Net Worth Firms: Investors may restrict lending to big firms because those firms have more to lose in a default and are therefore more meticulous.

Moral Hazard

  • Definition: The risk that a borrower will use funds for purposes other than those intended after the transaction has occurred.

  • The Principal-Agent Problem:     * Principals: The shareholders/owners of the firm.     * Agents: The managers hired by the owners to carry out their wishes.     * Problem: Managers may pursue personal objectives that differ from the interests of the shareholders, reducing shareholder value.

  • The Board of Directors: An intermediary body appointed by shareholders to oversee the CEO and ensure shareholder wishes are carried out.

  • Failures in Oversight:     * Co-option: CEOs often co-opt the board, turning them into a "rubber stamp" for their own decisions.     * Example: Theranos: Elizabeth Holmes co-opted her board; they failed to ask for proof that the technology worked and instead took everything at face value while collecting bonuses.     * Example: Silicon Valley Bank: Financial regulators and the board "fell asleep" and failed to police the CEO's actions.

Case Study: Disney (Eisner vs. Katzenberg)

  • Context: This case illustrates how a bad board of directors and a co-opted management structure can lead to poor decision-making.

  • The Figures:     * Michael Eisner: Former CEO of Disney.     * Jeffrey Katzenberg: Hired by Eisner to head Disney's failing movie business.

  • Success Under Katzenberg: Katzenberg turned the movie business into a "cash machine," producing classics including The Lion King, The Little Mermaid, Aladdin, and Beauty and the Beast.

  • Historical Milestone: Beauty and the Beast was the first Disney cartoon/movie nominated for the Academy Award for Best Picture (at the 1993 awards).

  • The Firing: Despite his massive success, Eisner fired Katzenberg.

  • Reasoning: Eisner viewed Katzenberg as a personal threat who might eventually take his job as CEO.

  • Board Failure: A smart board of directors should have blocked the firing of a manager who turned a failing business into a success. Instead, the board acted as a rubber stamp for Eisner's "cockamamie" plan.

  • Outcome: A spiteful Katzenberg co-founded DreamWorks, which became a powerhouse creating hits like Shrek and Kung Fu Panda.

Questions & Discussion

  • Q: Why was Jeffrey Katzenberg fired if he was so successful?     * A: He was fired because Michael Eisner was afraid Katzenberg would come for his job. It was a failure of the principal-agent dynamic where the CEO's personal fear overrode the company's best interest, and the board failed to provide proper oversight.