Not all who wander are lost

 J.R.R. Tolkien



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:

  1. Institutions: European Central Bank or International Monetary Fund, for example.
  2. Entities: Banks, Credit Unions, savings bank… and all kinds of companies included in the financial sector.
  3. 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[1], 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. [2]

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.[3]

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.[4]

Why is inflation dangerous?

The two main drivers of inflation are:

  1. An increase of the available money quantity.
  2. A velocity increase at which this money circulates.

Hence, if there is inflation, the possible dangers are:

  1. A situation in which you open the tap and no water comes out since there is no water in the pipelines.
  2. 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: