Specialization and Trade: A Re-introduction to Economics by Arnold Kling
Author:Arnold Kling [Kling, Arnold]
Language: eng
Format: epub
Published: 0101-01-01T00:00:00+00:00
Financial intermediation involves layers. For example, consider the fruit orchard. One way to fund a project to plant fruit trees would be to issue shares in the project. If the fruit trees cost $100,000 to plant and the company creates 1,000 shares, then each share will be priced initially at $100. Over the years, the value of those shares will then rise or fall depending on the health of the trees and on the state of the market for their fruit.
Savers who might purchase shares in the fruit trees will face several challenges. First, they may not know much about fruit growing or the fruit market, which makes it difficult for them to assess the risks and returns of their investment. Second, they may be uncomfortable holding an investment whose value can rise or fall, because they may need funds just at a time when the value of the investment has fallen. Third, they may not be sure whether the managers of the fruit orchard will “loot” the business by taking large salaries or by scrimping on maintenance.
Some of those problems can be addressed by having the business raise a portion of the funds by borrowing. Perhaps the business will issue only $20,000 in shares and will borrow the remaining $80,000 by issuing bonds, promising to repay the principal and a fixed rate of interest over time. Principal and interest on bonds are owed regardless of how well the fruit orchard project pans out. Savers who lend to the firm by purchasing its bonds instead of shares will have a more predictable path of cash flow and less to worry about with regard to management behavior.
The debt contract puts a gun to the head of managers. They must repay the debt on schedule, or they will lose control of the firm. (If the firm defaults on its debt, then its lenders can force it into bankruptcy, in which case the lenders take ownership of the firm’s assets away from its shareholders.)
For savers who hold debt of the firm, their position is not perfect. If they suddenly need cash, they will have to find someone to whom they can sell the firm’s bonds. Depending on the state of the market when the saver chooses to sell bonds, the saver could take a loss. In addition, holders of the firm’s bonds must spend resources monitoring the firm to ensure that its management is adhering to the terms in the debt contract.
As a further step in financial intermediation, a bank can purchase the firm’s debt, with the bank offering the public a combination of shares in the bank stock and bank deposits. Bank deposits can be withdrawn at any time. That factor eliminates the risk to a saver of having to suddenly sell bonds and perhaps take a loss.
The bank can also undertake the effort to evaluate the fruit industry and to monitor the specific firm’s management to see that it lives up to the terms of the debt contract. As a saver,
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