Finance (Part 2)

The first part of this article looked at the finance industry as a marketplace where those who have managed to save wealth, in the form of capital, can sell that wealth to those who need it in order to fund a business, infrastructure development or the purchasing of assets like, for example, the property for sale in Port Elizabeth. The following article will briefly look at a feature that is present in all markets, and is perhaps the very thing that comes to define a market as a market: Price. Whereas price in a commodity market is calculated on the cost of production (machinery used, wages paid, transport costs, etc.), the price of capital needs a different index from which it can be calculated. This index is primarily based on risk.

A fundamental concept which factors into the determination of the price of capital (interest) is the amount of risk that the lender takes on when lending. There is always a risk that a borrower (whether a business, individual or even a government) might not be able to pay the lender back the capital that they’ve borrowed. Some borrowers, however, could be considered to be at a greater risk of defaulting on payment than others: in this case, the lender will only be willing to assume that risk if the potential payoff (interest) is worth the risk. On low risk investments, lenders cannot expect a high rate of return (to earn high interest); but on high risk investments, the interest rate will be high, and hence so will the potential profits to the lender.

Without the incentive of earning interest, no one would save money, and no new investment would take place. The rate of economic growth would probably slow if this were the case (even though consumption would increase), but the most important side-effect is that markets would most likely become sluggish and inefficient. Efficient markets are markets in which supply meets demand at its best possible equilibrium point; it is often the case that this equilibrium point isn’t reached due to certain restraints (the cost of production, tax, etc.) and the market is therefore not at efficiency. Businesses strive to create markets that are at maximum efficiency (as it results in maximum profits) and investment capital is often needed to fund ventures that work towards that end. Additionally, investment is also needed to fund ventures designed to supply a market of new demands generated by the development of new technologies, other new markets, and new social demands.

Unfortunately, the finance industry is also subject to much abuse and misuse: as has been evidenced by the recent past, ill-considered investment (the unrestrained lending to high risk clients) has had disastrous results. Such actions are morally reprehensible as society as a whole ends up bearing the burden of overzealous, and greedy, investment fund managers. It is generally agreed that the system needs some issues to be addressed and reformed in order to better protect lenders from bad investment. However, as already stated, it is important that we note that capital, when judiciously used, has enormously beneficial effects for the creation of new businesses that meet new demands, and aiding already extant markets in reaching maximum efficiency. This is to say that capital placed at the disposal of industry renders a service to society vital to its growth and necessary for economic efficiency to be reached.

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