What Finance Is

Article / Produced by TOW Project
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Finance is that human activity whereby we allocate or exchange resources with respect to time. For the most part this article concerns external exchange—that is, borrowing, lending and investing—rather than allocation of resources within entities. The term “finance” will be used here as shorthand to refer to financial transactions among parties. Financial functions within households and institutions also concern the allocation of resources over time, and by analogy many of the same principles apply. Nonetheless internal finance—budgeting or project planning, for example—does have its own particular circumstances, which this article does not cover.

Finance occurs, then, when people who want to borrow some resources in a particular time period do so by entering into arrangements with people who have more resources than they currently need. The borrower is willing to pay a price (interest for example) to gain present access to the resources, and the lender wants to make a profit or return in the future from giving up access to the resources at present. Assuming all goes well, the lender benefits the borrower by providing resources at a time the borrower needs it (now), while the borrower benefits the lender by increasing the borrower’s resources in the future. If all goes well, the borrower uses the resources in such a way that both the borrower and lender are better off after the borrowed resources are returned to the lender.

To put it a bit more formally, finance is that human activity involved in the allocation and exchange of resources with respect to time. As a shorthand, we will use the term “lending” to refer to all forms of making resources available, including debt, equity, derivatives, etc. Thus lenders could be households with deposits at a bank, but could also be, for example, stock investors, private-equity investors, or employees contributing to a pension fund. Similarly, borrowers could be households with bank loans, but could also be, businesses selling stock, households borrowing to purchase a house, or government entities issuing bonds in open markets. In general, we are referring to market-based transactions undertaken in a mutually beneficial voluntary manner.[1] We will not develop a theology regarding non-market types of resource allocation—for example governmental or non-voluntary allocation of resources—which are more properly called “subsidies.” Also, since by “finance” we mean the exchange of resources at one time with the expectation of a reverse exchange of resources later, we are excluding labor markets, markets for goods and services, and the like, which are more properly called “trade.”

The earliest example may have been lending a hunting instrument to a fellow clansman for a period of time with the understanding that it would be returned later along with part of the kill. Perhaps a somewhat later example would be borrowing seed from a neighbor with the understanding that that amount of seed plus a little extra would be returned at the end of the growing season. Later, when currency was developed, more complex borrowing and lending transactions could be handled more easily. A successful fisher might sell the catch and have a bit of money left afterwards. A farmer could borrow that money, buy seed, grow grain, sell some of the grain crop and repay the fisher’s original money plus some interest. The fisher helps make the farmer successful and vice versa. In this way people benefit each other in ways beyond their personal skills or capabilities. The history of finance is the history of human creativity and social cooperation applied to make the earth’s God-given resources more productive.

Over the centuries several types of institutions have developed which greatly facilitate this borrowing and lending of resources. Banks, investment banks, mutual funds, microfinance organizations, credit unions and many other organizations have emerged to help borrowers and lenders find each other and to exchange and re-exchange resources to fit the needs of the borrowers and lenders. For example, mutual funds make it possible for people to invest modest amounts of money in an array of stocks and bonds that would be too costly and complex to invest in individually. The contracts or instruments used in finance include debt and equity as well as many hybrids and derivatives designed to suit particular borrower or saver needs.