What is the financial system?

One of the biggest problems for any economy is to figure out is how to get money from people who want to save to people who want to borrow. Finance is the answer to that problem. If you think of the economy as a body, finance would be the heart, pumping money from pension funds in Iowa to construction sites in Madrid. In economic terms, the financial system is responsible for a lot of the world’s resource allocation. It decides which investments get funded and which ones do not. This makes it quite important and quite powerful.

People talk about ‘the market’ like it’s a living thing, but in fact it’s a combination of billions of people’s actions and decisions. Prices are set by a huge number of banks, investors, and companies deciding to buy and sell financial assets. The prices for these financial assets help determine where money goes in the economy, directing money to things that are more likely to make money for investors.

At least that’s how it’s supposed to work. As we saw in 2008, sometimes financial markets can go horribly wrong, with prices skyrocketing and crashing without any obvious reason. When this happens it’s a lot like an economic heart attack.¹ When money stops moving around the system, everything dependent on that money is in trouble. While you might not have much to do with men in suits on Wall Street, your employer probably does, which is how problems in finance get turned into problems with your paycheck.