The Role of Financial Intermediaries in the Flow of Funds Through the Three-Sector Economy

A two- or three-sector economy is a highly simplified formal model of economic relations among its major macro-sections. The classical three-sector economy holds that the state, private businesses and household consumers are the three macro-level sectors of all modern economies. Their interaction makes up the major workings of all modern economic systems.

A financial intermediary is a set of institutions that include banks primarily, but also insurance firms, pension funds and investment funds, such as mutual funds. The purpose of all of these intermediaries is not to produce anything. Instead, they are to act as channels that bring money from one sector to another. The point of this is to make certain that investment money will be used in sectors that turn a profit. Banks will only lend to those who have a good chance of making money, just as insurance firms will not underwrite an investment unless it is up to all contemporary standards.

Within the three sector economy are three markets that are equally significant and general. The first is the product market, where all goods and services are sold. The second, the factors of production, such as productive capital and land, and third, the financial market, which represents the intermediaries. The financial market acts as a gatekeeper. Its purpose is the balance of efficiency and profit in investment capital with state interests in regulation and taxing of these investments.

The financial market has three specific aspects in this economic model. The first is to channel investment money to the most capable investors. The second is to take money from those saving in order to have ready investment capital on hand. Third, they pay a certain amount of their profit in taxes to the state. There is a two-sector economy where the state does not exist. Everything is governed by intermediaries such as private insurance or private banks, and only household consumption and business production exists as meaningful economic categories. In this two-tiered model, there is a public good. The public good is protected only by the state because, public goods such as health and safety are not marketable.

Modern states rarely can live within their means of raising taxes alone, and therefore, use financial intermediaries to borrow against any shortfall. This makes a certain amount of sense since the state cannot go bankrupt—it is a coercive rather than a market institution—and can thus carry a large amount of debt with regularity. As long as the domestic market remains strong and taxes are collected, even a large debt can be easily carried through recourse to money markets. Money easily flows to those parts of the economy that do well, such as stable firms and the state, since returns might be low, but at least guaranteed. Funds flow less readily to smaller and less stable firms.