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The Little Book of Economics: How the Economy Works in the Real World, Revised and Updated by Greg Ip

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Chapter Fifteen

Love-Hate Relationship

The Bipolar Financial System—Essential for Economic Growth but Sometimes It Goes Nuts

In tom wolfe’S 1987 novel Bonfire of the Vanities, a bond trader’s daughter asks him what he does for a living. His wife explains, “Just imagine that a bond is a slice of cake, and you didn’t bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that.”

That image pretty much sums up the popular view of financiers: They don’t make anything, they just get rich rearranging the fruits of others’ labor. At times of crisis, that cynicism turns venomous, such as when Charles Grassley, a Republican senator, in 2009 urged the richly paid employees of one bailed-out firm to resign or commit suicide.

Yet, finance is as essential to economic growth as it is unpopular among Congressmen. The financial system channels capital from those who have it to those who need it, much as the circulatory system moves blood from the heart to the lungs and muscles. A simple example shows how. Imagine that you have money to invest while a colleague at work needs money to buy a house. Why not bypass the bank, and lend him the money? Well, he may need more than you have. He may want to borrow it for 10 years but you only want to lend it for one year. Most important, you don’t know if he’ll pay it back.

The financial system solves all these problems. It matches savers with borrowers with neither having to know ...

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