2 - How finance differs

Summary

This book focuses not on the role of money in facilitating transactions, but on the role of credit in facilitating economic activity more broadly. It is remarkably difficult to incorporate credit within the standard general equilibrium model. Credit can be created with almost no input of conventional factors, and can just as easily be destroyed. There is no easy way to represent the supply function for credit.

The reason for this is simple: credit is based on information. Ascertaining that an individual is credit worthy requires resources; and standing by that judgment, providing or guaranteeing credit entails risk bearing. There is no simple relationship between these economic costs and the amount of credit extended.

The physical capital with which we produce in our factories and fields may be slightly affected by outside disturbances – rain may lead to rust – but only major cataclysms, such as wars, can have a significant effect in the short run. However, informational capital can be far more easily lost or made obsolescent. Changes in relative prices, for instance, require a reevaluation of individuals and firms' credit worthiness.

Interest rates are not like conventional prices and the capital market is not like an auction market

The standard general equilibrium model is not helpful in understanding credit markets, and may even be misleading. misleading because we are apt to think of the price of credit – the interest rate – being a price like any other price, adjusting to clear the market.