By ROBERT J. SAMUELSON [Claremont Review of Books] – Broadly defined, the purpose of finance is to provide ways for society to save and invest, to give people and firms a choice between spending now and spending later, to match borrowers and lenders. Without reliable ways to save, societies would remain mostly present-oriented, and investment in new productive capacity and technologies—the foundation of economic growth—would be hamstrung. People would bury their savings. Businesses could only invest from accumulated profits. Households would strain to save for future needs—retirement, college, unexpected illnesses—because their savings would earn no returns. They would also have to defer many desires (buying a car, taking a long vacation) until they had ample savings to do so.

Since World War II, numerous financial innovations have created large public benefits. Credit cards have made it easier for consumers to borrow. Venture capital funds have financed new technologies and industries, notably, personal computers and many internet applications. Junk bonds have given non-blue chip companies another source of borrowing aside from banks, as well as providing financing to buy and break-up unwieldy conglomerates. The liberalization of mortgages helped millions of Americans to become homeowners. All good.

But there was a catch. In each of these cases, the process went to destructive excess. Venture capital firms financed too many dubious dotcom startups, contributing to the tech bubble of the late 1990s. Credit cards were marketed at excessive interest rates to many households that couldn’t handle them. Junk bonds encouraged some companies to assume too much debt, leading to bankruptcy. And most menacingly, the liberalization of home mortgages spawned the brutal crisis of 2007-09. The paradox of modern finance is thus silhouetted: advanced economies require sophisticated financial systems, but these also threaten economic stability. Is it possible to defeat the paradox?

Conitnued at The Claremont Review of Books | More Chronicle & Notices.