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Lavf58.29.100 Econ 350 Money and Finance Topic 1: Introduction 1 Lecturer: Sean Turnell 2 …the ascent of money has been one of the driving forces behind human progress: a complex process of innovation, intermediation and integration that has been as vital as the advance of science or the spread of law in mankind’s escape from the drudgery of subsistence agriculture and the misery of the Malthusian trap. Niall Ferguson (2008:342) 3 4 5 The financial system [is] the brain of the economy…It acts as a coordinating mechanism that allocates capital, the lifeblood of economic activity, to its most productive uses by businesses and households. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently, and ultimately economic growth will be low. Frederic Mishkin (2006) 6 But, as recent events have shown only too well, the ascent of finance has not been a smooth one. In fact, financial history is a roller-coaster ride of ups and downs, manias and panics, bubbles and busts, shocks and crashes. Since 1870, there have been 148 crises in which a country experienced a cumulative decline in GDP of at least 10% and 87 crises in which consumption suffered a fall of comparable magnitude. In recent history, we have witnessed the 1929, 1987, and 2007-2008 crises. Three reasons for the inherent instability of financial system: So much about the futures lies in the realm of uncertainty as opposed to calculable risk. Human behavior, that means for many occasions, people behave irrationally (we will dig into this issue in Topic 9 Behavioural Finance). Evolutionary characters of finance (Topic 2). 7 8 Contents: I. What is Money and where does it come from? II. The role of finance III. Financial markets 9 I. What is money and where does it come from? Topic 2: The Evolution of Money and Finance, and Topic 10: Cruptocurrencies. 10 The important point to note about all of them is that they have value because of the social arrangements each implies. And in this, money: …unites society more effectively than tyranny or blood; for, in taking money, you deliver yourself up to the other users of money, accept their freedom to choose, their frivolity and selfishness, their universal subjection to desire, their humanity’. Buchan 1997:20 The nature of money as transferable credit/debt Martin (2013: 26) puts it: …all money is credit, not all credit is money: and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between just two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third party… 11 The Island of Stone Money 12 The economy of Yap was far from developed (it had only three products, few animals, no or minimum trade with outsiders). But its coinage was extremely unusual. It consisted of fei – ‘large, solid, thick stone wheels ranging in diameter from a foot to twelve feet. 13 The value of the coins depended principally on their size, but also on the fineness of the grain and the whiteness of the limestone. Numerous transactions took place, but the debts incurred were typically just offset against each other, with any outstanding balance carried forward in expectation of some future exchange. Even when open balances were felt to require settlement, it was not usual for fei to be physically exchanged. John Maynard Keynes thought these people of Yap had a clear understanding of the nature of money. They understood that the tokens we use like coins or paper money are not money. What these tokens represent is money and is a system of credit and clearing which enables use to transact with one another. These Yap people saw much clearly than the Western Europeans or Americans in Keynes’ days. They were fixated on the idea of gold as money, the gold standard. The case of Irish bank closure 14 • On May 1 1970, the entire banking system in Ireland was shut due to the severe breakdown in industrial relations between the banks and their employees. • However, transactions continued to take place via IOUs in the form of cheques. But these cheques could not be cashed at the end of every business day due to the closure of banks. • The Republic’s pubs and small shops served as nodes in the system of personalized credit by collecting, endorsing and clearing cheques. • By the time the banks and their employees finally reached the agreement, over 5 billion pounds of uncleared cheques were written. • This was the money that the Irish public had made for itself while its banks were on strike. 15 ‘Moneyness’ is not an intrinsic attribute, and does not have a particular form – but represents the ability to acquire. According to Buchan (1997:19) money is incarnate desire: …money has always and will always symbolise different things to different people…to one person a drink in a pub, a fairground ride, to a third a diamond ring, an act of charity to a fourth, relief from prosecution to a fifth and, to a sixth, simply the sensations of comfort or security. 16 Schopenhauer (1968:414) made an almost identical point: Men are often criticised in that money is the chief object of their wishes and is preferred above all else, but it is natural, even unavoidable. For money is an inexhaustible Proteus, ever ready to change itself into the present object of our changeable wishes and manifold needs. Other goods can satisfy only one wish and one need. Food is good only for the hungry…medicine for the sick, fur for the winter…Money alone is the absolute good: for it confronts not just one concrete need, but Need in itself in abstract. 17 II. The role of finance Financial systems are special, peculiar and distinctive on many fronts: 1. They constitute the heart and the brain of the market economy – pumping money (credit) from those who have it but don’t need it (surplus units), to those who need it but don’t have it (deficit units) through both financial markets and institutions. 2. Financial sector facilitates trade by creating an efficient and secure payments system. 3. Financial sector creates products for the management of risk – futures, options, insurance contracts, etc. Nevertheless, risk has never been abolished, and sometimes it’s enhanced by the complexity of financial products. 18 4. Financial systems are the arenas through which government implements a critical arm of monetary policy. It constitutes a medium, as well as a marketplace. (We’ll look into this role in Topic 3: Interest rate, and Topic 4: Central banking and Monetary Policy) 5. Finance is a projection into the unknowable future, and financial products are promises to pay. Because of this, it is uniquely vulnerable amongst markets to all the human frailties – fear, greed, vanity, ignorance, fraud. Thus, finance is heavily affected by law, except “if men were angels, no Government would be necessary” (Martin, 2013: 73). Some of the regulations raise singular concerns of ‘moral hazard’ and other behaviour distortions not present in other markets. Robert Shiller’s view on Finance Finance is the science of goal architecture. The goals may be those of households, small businesses, corporations, civic institutions, governments, and of society itself. Once a goal has been specified, the parties involved need the right financial tools to help achieve the goal. (Note that the word “finance” actually derives from a classical Latin word “finis”, meaning goal or completion.) Finance, despite its flaws and excesses, is a force that potentially can help us create a better, more prosperous, and more equitable society. In fact, finance has been central to the rise of prosperous market economies in the modern age—indeed this rise would be unimaginable without it. 19 http://www8.gsb.columbia.edu/rtfiles/finance/Finance%20Seminar/Fall%202011/Robert%20Shill er.pdf 20 Finance is BIG. Global GDP = ~ $80trn (2017) and ~ $84.8trn (2018) Global capital markets are much bigger (see next slides) In 2007, the RBS’s total assets were larger than the UK’s GDP. In 1947, the US financial system accounted for 2.3% of that country’s GDP. In recent years it contributes ~ 8%. In the UK and Australia its contribution is ~ 9%. 21 22 23 Throughout the history of Western civilization, there has been a recurrent hostility to finance and financiers, rooted in the idea that those who make their living from lending money are somehow parasitical on the 'real’ economic activities of agriculture and manufacturing. Why the hostility? Three reasons according to Ferguson (2008:2-3): 1. Debtors outnumber creditors 2. Crises and downturns have often appeared to have a financial cause 3. Finance in many places has been disproportionately provided by ethnic and/or religious minorities. 4. Modern view: financial sector growth is bad for the rest of the economy!! 24 Channels of transferring funds from surplus to deficit units: By direct financing, we mean the situation in which deficit and surplus units deal with each other directly rather than through an intermediary, mostly through financial markets. Deficit units issue financial claims (securities – bonds, bills, notes, shares), while surplus units supply funds by buying these claims. Brokers (such as investment banks and other dealers) usually facilitate the process of creating these claims, and in bringing the deficit and surplus units together in the market place. In practice, direct financing takes place in the bond market, equity markets, money markets, etc. Such markets, and the products they trade, are central to this course. 25 Indirect Financing. A financial intermediary (simply, a bank) stands between (ie, ‘intermediates’) surplus and deficit units. In other words, the intermediary creates separate contracts for a transaction between