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«A special report on the future of finance

Wild-animal spirits

Jan 22nd 2009
From The Economist online edition

Why is finance so unstable?

In fact, observes Abhijit Banerjee, an economist at the Massachusetts Institute of Technology, a little irrationality goes a long way. When reasonable, self-interested people trade with each other, optimism tends to breed optimism—until it subsides into corrosive pessimism. In the words of Willem Buiter, of the London School of Economics, “finance is a scary, inherently unstable, essential activity.”
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Asset prices pull themselves up by their own bootstraps. As houses become more valuable, house owners feel richer. If they then spend more, companies make more money, which in turn increases the value of shares and bonds. Profitable companies invest and create jobs. As the economy thrives, there are fewer defaults. Lenders are therefore willing to lend more on easier terms. This extra credit makes asset markets liquid: if ever you need to sell something, there always seems to be a ready buyer. Ample credit also tends to feed into spending and asset prices. That makes people feel richer. And so it goes on.»

Illustration by S. Kambayashi

. . . ou ainda na mesma revista . . .

Imagine, for a second, how finance began, with small loans within families and between trusted friends. As the circle of lenders and borrowers grew, financial transactions were able to muster larger sums and to spread risk, even as promises became harder to enforce. Paul Seabright, an economist at the University of Toulouse in France, observes that trust in a modern economy has evolved to the miraculous point where people give complete strangers sums of money they would not dream of entrusting to their next-door neighbours. From that a further miracle follows, for trust is what raises the billions of dollars that fund modern industry.