Asymmetric information occurs when one party knows more about an economic transaction or asset than the other party does, and adverse selection occurs before a transaction takes place. If unmitigated, lenders and insurers will attract the worst risks.

Finance also suffers from a peculiar problem that is not easily overcome by just anybody. Undoubtedly, you’ve already encountered the concept of opportunity costs, the nasty fact that to obtain X you must give up Y, that you can’t have your cake and eat it too. You may not have heard of asymmetric information, another nasty fact that makes life much more complicated. Likescarcity, asymmetric information inheres in nature, the devil incarnate. That is but a slight exaggeration. When a seller (borrower, a seller of securities) knows more than a buyer (lender or investor, a buyer of securities), only trouble can result. Like the devil in Dante’s Inferno, this devil has two big ugly heads, adverse selection, which raises Cain before a contract is signed, and moral hazard, which entails sinning after contract consummation. (Later, we’ll learn about a third head, the principalagency problem, a special type of moral hazard.)

Due to adverse selection, the fact that the riskiest borrowers are the ones who most strongly desire loans, lenders attract sundry rogues, knaves, thieves, and ne’er-do-wells, like pollen-laden flowers attract bees (Natty Light attracts frat boys?). If they are unaware of that selection bias, lenders will find themselves burned so often that they will prefer to keep their savings under their mattresses rather than risk lending it. Unless recognized and effectively countered, moral hazard will lead to the same suboptimal outcome. After a loan has been made, even good borrowers sometimes turn into thieves because they realize that they can gamble with other people’s money. So instead of setting up a nice little ice cream shop with the loan as they promised, a disturbing number decide instead to try to get rich quick by taking a quick trip to Vegas or Atlantic City for some potentially lucrative fun at the blackjack table. If they lose, they think it is no biggie because it wasn’t their money.

One of the major functions of the financial system is to tangle with those devilish information asymmetries. It never kills asymmetry, but it usually reduces its influence enough to let businesses and other borrowers obtain funds cheaply enough to allow them to grow, become more efficient, innovate, invent, and expand into new markets. By providing relatively inexpensive forms of external finance, financial systems make it possible for entrepreneurs and other firms to test their ideas in the marketplace. They do so by eliminating, or at least reducing, two major constraints on liquidity and capital, or the need for short-term cash and long-term dedicated funds. They reduce those constraints in two major ways: directly (though often with the aid of facilitators) viamarkets and indirectly via intermediaries. Another way to think about that is to realize that the financial system makes it easy to trade intertemporally, or across time. Instead of immediately paying for supplies with cash, companies can use the financial system to acquire what they need today and pay for it tomorrow, next week, next month, or next year, giving them time to produce and distribute their products.