Falkenstein on Book 1
I found their general description of finance to have a misleading emphasis. There was an exposition where assets have risk characteristics that are obscured as they are passed up a food chain, until finally there is greater liquidity, but less information available. Risk is transferred, but because of the lack of transparency, it actually increases.
Clearly, there is transferral of risk in finance, but I think this is not the essence of finance. Finance is intermediation, taking money from savers and giving to people who want to use that money. They, in turn, promise to pay it back. The process generates prices that act as signals to inform those borrowers and savers how best to borrow or save.
I agree that we did not have time to give a full exposition of finance. However, I do believe that the risk “hiding” function that we described has some validity. Riccardo Rebonato subsequently wrote a book about it. I have also written more about it subsequently.
The rationale for including a section on finance in the book is that we are focusing on intangible factors that we think are underemphasized in mainstream economics. Mainstream economics is always tempted to Modigliani-Millerize, that is to treat finance as a “veil” through which people can see. There is a striking contrast between textbook economics, which is hard-pressed to explain why financial intermediation even exists, and the practical policy world, where the failure of a financial institution is viewed as having dire consequences.
In the past two years, I and many others have put a lot of thought into how to find a reasonable medium between the “irrelevance” theorems and the “failure is unthinkable” policy responses. The book was written three years ago, before this issue came to the fore. So it is hard to dispute Falkenstein’s view that our discussion of financial intermediation is not satisfying in the present context. Fortunately, he is more positive about the rest of the book.