Not all who wander are lost
When I was a teenager the 2008 Crisis theme got me really hanged up, which is why for years I have been obsessed with the financial system, a sector which I currently work for.
In 2008 the media was constantly speaking about the crisis and that there was no money left. Many of my relatives experienced a really harsh period and their situation was catastrophic at the time. I always wonder myself: If everyone is still working, how is it possible that there is no money? How is it possible that banks have run out of money? Where has all this money run to?
Twelve years later it has happening again, but in this occasion, I fully understand what thing is about. It has cost me a lot of effort and time to understand it. Therefore, I came with the idea to write a set series of articles, facilitating the exhausting work of understanding such concepts for those that will come after me.
I think that what happened in 2008 is happening again, and this time banks have not been the catalyst (origin), but the Public Health System. As a result of this event, many things are going to change in the nearby future, and since many of you are in quarantine you might take advantage of the situation and kind of understand how the world works, specially from the financial system perspective.
In this blog series that I have called Finaceconomics 101, I want you to learn enough economy and finance to:
-Read and watch the news understanding perfectly what they are talking about.
-Build or create your own idea about the economic project you want for your life and your country.
-Make good decisions in your daily life taking advantage of this knowledge.
The two first posts are about really simple and basic concepts, and I will build the rest of the posts based on these concepts. I promise you that if you get these ideas and you insert them in your mind, you will have a really solid base to understand complex bodies of knowledge.
I am going to use an unfamiliar system to explain you the current circumstances, since honestly it is quite a big theme and it requires to be really tidy when explain it. This system is based on the idea of, instead of giving you something to read as dull as ditchwater, I will be connecting explanations to questions and answers. Therefore, you will need to understand a first metaphor and three main ideas.
The questions I am going to answer in this post are:
What is the financial system? What is it purpose?
What is inflation? Why is it dangerous?
What is money?
Why do we need middlemen?
What is GDP?
What is a bubble?
Before starting, and to ease your understanding, I will propose you a metaphor that I will use continuously.
Imagine that money is water.
For million of years, men have been subject to weather conditions and were nomads since when there was no rain, they had to migrate. But, at given time a genius started to collect the water fallen from the sky and store it, hence when there was no water, he would have a bucket to dip into. How the story follows, you already know: today, in our homes when we open the tap and water stars pouring out.
Thanks to the fact that men have created an artificial system to transfer water and control it, nowadays you can open the tap and drink a glass of water. This system eases water to everyone and it enables us to control water in our plantations and homes optimizing its use to the fullest.
Throughout my explanation I will frequently use this analogy, expanding it and adding details.
Let´s start! I am going to give you three keys, with them you will be able to open the different chest that you will be finding throughout this adventure. I will explain you three ideas.
The First idea that I want you to learn is that the financial system is made of:
- Institutions: European Central Bank or International Monetary Fund, for example.
- Entities: Banks, Credit Unions, savings bank… and all kinds of companies included in the financial sector.
- Markets: Places where institutions and entities interact with each other, like your local town market, but at a bigger scale
Interacting with one another they become the middleman between people who want to invest (Savers/Investors) and people who have inversion ideas (creators).
But what is the concluding goal of the financial system as a whole?
Personally, I think that the aim of the financial system is to ease the transit of a person, who comes from an absolute poverty condition, to absolute wealth only by his capacity to create value and his personal effort.
The second key concept, coming back to the water analogy, is that the increase/decrease of water from one year to another in the plumbing system is called inflation. Many factors can be taken into account when measuring the inflation, but the two most important are the amount of available water (Monetary Mass) and the pressure at which the water comes out when we open the tap (Money velocity)
The third idea is to understand the difference between fiduciary money and money based on the gold standard. I have tried to find a short video, without biased opinions that would explain the difference, but unfortunately, I have not found one, so here is my explanation:
1st Money based on the Gold Standard means that you could go whenever you wished to the Central Bank and change your cash for the equivalent amount of gold that your cash can provide you. Money is just an object which represents a fraction of gold reserves a central bank has in its safes and the Central Bank cannot print more banknotes until it gets more gold
To do business in this system you need two things: gold as a payment method and trust. Gold is used because its quite a rare material and it’s difficult to find nor it can be multiplied as paper. And for the second thing, when making business people have to trust each other, you need to have faith on the people you are dealing with.
2nd On the other hand we have the fiduciary money. To explain it we need to have a bit of a historical insight. In the 70s they realized that obtaining gold was not that easy to find and, even if it was a, you always needed a mechanism to ensure business and give stability to the system, so maybe what was really irreplaceable was trust.
Being there gold or not, trust was something that could not be ignored. Your gold might get stolen, they might rip off you with gold, and even you can get the wrong price you pay for something with or without gold.
It was then when they thought that gold was not really necessary and with the faith you had in other people which who you made business with could be enough. Fiat or fiduciary money was born.
Fiduciary money is not backed up by gold in Central Bank’s chest. It is based on the confidence you have on the person supplying you cash. It’s not the same a US dollar, issued by the USA, to a Narnia dollar issued by a speaking lion. 
The Central Bank can decide to print as much money as it feels, even if it does not have an equivalent amount of gold in its chambers. It has more freedom to apply economic measures and intervene the economy. The Central Bank prints banknotes backed by the trust you have on the institution that is printing them as well as in the society which has established this institution, not on the amount of golden rocks you have in your basement.
All the develop countries have fiduciary money, however there is an ongoing debate about which system is the best option.
This debate comes from the idea that it is much more difficult to measure confidence without gold, which can give one a wrong idea of how much wealth there really is in the system, therefore creating big economic bubbles. In the end, gold is something material and the fact that you have gold implies that you have done business in order to obtain it. It is a good and reliable indicator that one can do business with you.
Well then, with these three ideas well internalized, we will head to the questions that I am sure they are building up in your heads.
Why is it necessary to have a middleman between savers and creators?
In order to have a common ground for all players with the same rules, to connect two people no matter the distance or the language, to reduce costs that appear every time a business negotiation starts from zero and to have more efficient markets…in the end, for many reasons.
Imagine you have a pastry shop business, and you need cocoa, which it is only found in Zimbabwe, and in order to buy it from Zimbabwe you need Zimbabwe’s dollars, they do not accept any other currency.
In a world without intermediaries you would have to learn the Zimbabwe tribe language, travel to Zimbabwe, negotiate with them, come back to your town, find people who would have faith in your pastry business, get them to lend you some money (let’s say euros), go back to Zimbabwe, negotiate at the border a decent currency exchange, go back to the tribe, by cocoa and bring it back to your home town. Thanks to intermediaries it is possible that, without you leaving your business, to have in less than a week the so much needed cocoa for your pastries.
The quality and variety of the financial products and the type of exchanges (business) that one can find in a market is called market depth. The deeper the market, the richer the market, because as more satisfactory exchanges are fulfilled, more people earn money and more wealth is generated.
Imagine a supermarket with an infinite number of products that is constantly restocked, this an indicator that the supermarket has both good suppliers and buyers. It´s a good indicator of confidence in an economic system.
Why do we need a middleman? Why can’t the middleman be centralized? Why can’t there be a public bank?
It is a very complex problem, but has all been solved for some time now with numbers and studies. It is an ongoing current debate because politician use this idea as political football. In the specialized and serious world no one suggests anything similar, since time and time again it has been demonstrated that the Public Bank is highly inefficient and it doesn’t help redistribute wealth nor to create it. It’s just a pretext for political corruption.
However, if you are sceptic and believe that academics cannot prove the reasoning, I will challenge you with another perspective.
Intermediaries cannot be public because the size of these institutions is intrinsically dangerous, and can lead to bigger catastrophes if a problem occurs. And this not about capitalism, nor socialism, nor academicism. It’s just as true as 2+2 is 4. And to get a real sense of it, the 2008 Crisis in Spain is a great close example.
And the biggest issue is that when they become big structures, they become slow, highly bureaucratic and block new efficient and novel ways of intermediation entering the market. There are so ingrained in the system that they become or paralyze or the system, and when this happens, competing against them is competing against the system.
They don’t move because its size and inertia make their movement really difficult, it´s not the same to change an organization made up by 3 persons that have been together 2 months than changing an organization made up by 1.000.000 persons who have been working the same way for the last 50 years. In a technological society as ours where everything changes every 10 years they have a lot of problems to survive because they don’t have time to change and there are a lot of interest of a lot of different group of persons that make them slow and fragile.
When a small fish as an entrepreneur create a risk for their survival thanks to a new and more optimized way of acting, or with a new technology, or with an optimized organization that allow them to adapt themselves faster and better to a new reality, these big governments and monopolies are going to create them burocracy problems because they are risking the way of life of the vast majority of the society, who work for these uber-structures and whose workers can´t change or don’t want to change. If you are deeply interested in this topic I addressed you a few links and studies in the footnotes.
Imagine a water infrastructure in big city such as Madrid, that it still made up of stone gutters, enormous pipelines and plumbing more the 500 years old. I am quite sure that the first people who arrived to Madrid build their house near the river and nowadays the water flows in their house in big amounts and without ever stopping, having more water than they actually need.
But if you live in the outsides of Madrid, the water that you will receive will have pass through the whole pipeline full of creaks and poorly maintained. You will receive dirty and scarce water to your home. A great deal of the water will be lost due to the poor conditions in which the old and inefficient plumbing system is build. What will be the key matter for your survival is to understand how the pipeline system works and that your grandfather builds the family home near the river.
Whether you believe academics or not, there are there are reasons to establish this idea as one of the bases to the explanation of this story. Even if the final turn could call this reason into question, for now speaking of the past and present we can conclude this idea.
Why is inflation dangerous?
The two main drivers of inflation are:
- An increase of the available money quantity.
- A velocity increase at which this money circulates.
Hence, if there is inflation, the possible dangers are:
- A situation in which you open the tap and no water comes out since there is no water in the pipelines.
- A situation where water comes out with no pressure, there still water, but it takes you three hours to fill a glass.
Small secret: in reality no one agrees what inflation is or how should we calculate it. In the end it is calculated depending on the interests the person behind the calculations has, leading to great distortions in the market. The most frequent way to measure it is how much has the GDP changed from one year to another.
Basically, the Spanish GDP is:
ALL the things that Spain has produced in a year at a given cost.
It´s like going to the supermarket, buying all the products that have been produced that year and put them in your trolley.
And the inflation would be the difference between the tickets you pay one year and the previous, once you’ve passed your trolley through the cash register. The ticket might have increase because of two reasons, you have bought more products than the previous year or the items have become pricier.
But again, try to agree on which products you should put in your trolley and how much should each item cost.
Being something so difficult to explain to the average Joe and requiring a big picture approach it’s an easily deceiving concept:
Take a look at this video:
I will place you then in two situations:
Imagine that you have one euro, and the mayor comes to you and gives you another coin because he thought that this way we would be twice richer, he used his cloning machine and now you are 100% richer.
Imagine the next day he gives you another two coins: you are 200% richer. Anybody experienced in life knows that nothing is free, and anybody would think that the major is tricking him some way. When the year is finished, instead of saving 10 euros like last year, thanks to the mayor you have saved 100 euros.
Now you can imagine that you had saved for the last 10 years because you want to buy a house, and suddenly , the 100 euros that you saved are worthless because now people have their 100 euros without going to work thanks to the cloning machine of the mayor.
Now the house you wanted cost 1000 because people who works building homes want to earn more. Who is going to work if staying in home you have the same amount of money? Before people needed to work to get 100 euros, but now the mayor gives you 100 euros if you breath. Therefore, people who demand work ask for more money or they won´t work as they need to sacrifice themselves working and it´s no longer worth it.
You, as a saver, were stupid sacrificing yourself during 10 years and living under your possibilities because with those 100 euros you could have traveled 10 times before the mayor printed the money and now you can´t even buy a chocolate bar.
We currently live in modern and civilized society, where progress needs big savers who are willing to lend money to promote challenging projects. Imagine if money would multiple by itself in an arbitrary way.
Its not equally challenging to develop a high-speed railway for country such as Spain than to pave your town’s streets. The more we progress, the more it becomes necessary to develop large projects impulse by collective achievements. Next year, thanks to the mayor we will have 100 euros in the pocket, so it´s better to spend them and be less worried as we are not safe about the progress way of our sociey, or if you lend it to people to create businesses you can´t be sure about that they will return it to you.
Now, when we talk about the second factor: the speed of money, imagine if we start to interchange the golden coin in our system every millisecond. If you would be able to take a picture, you would think that we are exchanging many coins, but in reality, we are always exchanging the one above-mentioned coin.
In times of speculation (like in a Real Estate bubble) everyone is exchanging the coin at an outrageous speed, giving the feeling that there are many coins in the system. But once the music stops, the one person who doesn’t have the coin in his pocket will have to start watering his soup (as poor as church mouse). People were making a song and dance about investing and lending more coins, but in reality, there was only one coin and the actual circumstance is that the one random fellow lending actually did not have the coin nor does the person who he (Mr. random fellow) has to pay-back.
So, what suddenly happens is that people start to drop like flies, ones because they do not have the money to pay back their debts and others because they are not getting paid. Hence, a domino effect generates, leading to a panic strike. Austria (1922), Germany (1923), China (1950), Brasil (1990), Argentina (1980s), Russia (1992), Yugoslavia (1994) and Zimbabwe (2006). You can search them on the internet to get good examples about hyperinflation.
As you might observe inflation is necessary. Money has to change hands often and it is necessary that there is money for everyone, even if it has a lower representative value of the real generated wealth. But, what ever you do, whether raise the amount of coins or raise the speed at which money is exchanged, we are always having a distorted image of reality since neither option backs the real generated wealth.
The law-making body (legislator) is responsible for establishing norms and avoiding these kinds of situations, keeping inflation at bay so money both matches generated wealth and goods and services produced. In the second part we will learnt thar central banks defines macroeconomic policy, therefore they are the ones who calculate how much money should be circulating to adjust inflation to the economic reality.
Money should bear relationship with the goods produced and with the service added value. When there is a mismatch between the value of those goods and services with the available printed money, we find ourselves in a possible hyperinflation situation.
Hyperinflation is more controversial subject than the one between Gold Standard vs. fiduciary money. There is tons of people whos’ job is to wait for a crisis, take advantage of peoples’ perception errors and then cash in their profits.
In future chapters, I will speak more about this topic, but for the instant I will make you two new questions:
1st. A fire breaks-out in a forest. Who will perceive the break-out better, the forest guard standing guard in a watch-post or a random guy having a sandwich under a tree?
2nd imagine a farmer that in a situation with high inflation ask for a loan to the bank for his new project of olive oil crop. He pays a high amount of money because he know how much can he produce and how much he can earn selling that olive oil, he doesn’t know about macroeconomics and he doesn’t know that there is high inflation.
When bubble bursts, prices go down and he realizes that he can´t pay for the loan because when he goes to market to sell his oil, he gain less than he has calculated in the hyperinflation situation. Do you think is fair that he loses everything he has? Do you think is fair he losses everything because he doesn´t know about macroeconomics? Do you think is optimal for the society to lose a lot of good farmers due to bubbles?
You already have the three keys to begin this adventure, but you’re still missing the swiss knife that will be very useful in the following chapter. This swiss-knife will open for you many doors and it is brutal life-hack, let me introduce you to:
Don’t freak off, as always, math drawings are much more difficult than what is really behind them.
Imagine we go to a university entry exam where students’ average grade has been a 5/10, imagine a pick a random student and tell you:
- “If you guess this dude’s grade, I’ll give you 5 million euros”
It is complete impossible to guess it, but if you draw a graph and you put in the vertical stick the number of students and the horizontal stick the grades, and you repeat this process with each and every student you will get this drawing:
Are you telling me that if whatever thing I want to know and ask 2,500,000 persons and this bell-shaped drawing will always appear? Yes.
I don’t mean that the random student has had a 5 on his test, what I am saying is there a much bigger chance that he has scored a 5 than a 10, because there many more students with a 5 than with a 10 or a 1.
So, if you would really want to win those 5 million dollars, you could rephrase the question in a trickier way.
- If we ask 5,000 students and there are more students with a 5 than any other number you will give me 5 million euros.
- Let’s ask 5,000 students, every time a student has had a 1 or a 10 I ll give you 5 million euros, but you will give me 5 million euros every time we find a student with a five.
As you can imagine you can use this graph in infinite ways, its none other than the Law of Large Numbers which many people become rich in their life time using it. Because it really works, but you need infinite numbers and define really well what you want to measure.
However, with great power comes great responsibility. Many people can make money with the Law of Large Numbers but they can also trick a lot of people who do not know about.
Let’s now go into a time machine, precisely to the years 2000s