We use it every day, but we don't think about the concept itself too much. When we see the word "money", we probably think "cash," or the balance in our bank account. But what is money exactly?
Money is a medium or asset that is widely accepted as payment for goods and services. While money can take many different forms, they have certain shared characteristics.
- It can be used as a means of payment.
- It has distinct units that allow us to assign prices to goods and services.
- It stores value - in case we want to spend it in the future.
Sure, these sound nice and rather obvious given the world we live in today, but why are these characteristics important?
Before standardized money was widespread among different societies, barter systems were the mediums through which people
exchanged goods and services. For example, if you had a cow and you wanted to exchange it for 3 pigs, but your friend only had 2, you would be a little inconvenienced to try to find someone else in the village who had 3. But if you both had money, then you could buy the pigs from your friend for a certain price and vice versa.
This situation illustrates the benefits of all three characteristics of money. The parties involved can use it for payment, assign prices, and store value - in case you didn't want all of your wealth in the form of cows for the rest of your life. But what should you use as money? This has evolved over time and is changing at an even faster pace in today's society.
For most of recorded history, our preferred choice of money was at first coins, and then paper money. There are three fundamentally different concepts of currency.
- Commodity Money - contains intrinsic value, for example a gold, silver, or copper coin.
- Representative Money - does not have intrinsic value, but can be reliably exchanged for a commodity that has value. An example could be a paper currency issued by a central bank that is backed by gold or silver held by the central bank.
- Fiat Money - has value based on government decree, faith in stability of government. An example is the current U.S. dollar which is not backed by anything other than faith in the government and central bank.
One of the important transformations of monetary systems is from commodity to fiat money.The notion that virtually worthless pieces of paper can now be used as money increased dramatically the flexibility of goverments to deal with finances and regulate economies. With this flexibility also comes risks such as inflation, a general rise in prices in goods and services that essentially devalues a unit of currency. One extreme instance of inflation in history is that of Germany in the 1920s when the price of a loaf of bread went from around 2 marks in early 1922 to around 2,000,000,000 marks in late 1923, at which point the German mark was basically worthless.
Paper money has evolved throughout the 20th cenutry, but in the 21st century, electronic payments have transformed our world even more. From debit cards and credit cards to Paypal, Venmo, and even WeChat in China, money in our world is constantly evolving. In China, WeChat is a popular messaging platform that has evolved to do many things from ordering food and taxis to paying bills and booking doctor's appointments, rendering credit cards and cash obsolete for many of the younger generation.
When we borrow money from someone, we pay back the sum, or principal, and then a little some. This bit of extra payment is interest. Why does interest exist?
When we borrow amount X from someone in one form or another, they are giving up their money for a period of time. Because they won't have access to amount X for some time to use for other expenses and investments, they expect to be compensated.
This interest can be thought of as compensating for the opportunity cost of our lender not investing in something else. It can also be thought of as a time value of money, conceptualizing the notion that $100 at present is worth more than $100 received in the future. We can think about it this way - if I have $100 right now, I have the option to spend it at anytime in the future. But if I receive $100 a month from now, I will miss out on some opportunities this month, so it is worth less than $100 in the present. We can also think of interest in terms of compensating the lender/investor for the risk he/she is taking on. Usually, the higher the risk, the higher the interest rate. It is like a reward for the investor taking on risk, enough so it is an attractive investment. To summarize our concepts of interest:
- Opportunity Cost
- Time Value of Money
- Risk vs. Return
Banks emerged over time as one of the fundamental institutions of finance. A bank's basic business is to provide a place for people to deposit their money and lend it back out at a higher interest rate, locking in a spread as profit. We take it for granted in our daily lives, but how did they arise?
Banks did not always store money. In ancient times when standard forms of currency were not widespread, banks had already come into existence for the function of storing commodities, such as grain or gold. Although banks did give out loans, often times they were acting as intermediaries between lenders and borrowers rather than physically taking assets onto their balance sheets.
Nowadays, banks have become even more sophisticated entities providing a variety of services other than deposits and lending. We shall get to these specifics later on, but for now, let's just appreciate that we don't have to haul ourselves to village center to get coins every time we want to buy something.
Ancient Greece & Rome
Although there were other ancient civilizations who made significant advances in finance before Greece and Rome, much of the foundation of modern finance in Europe was set up by these two great civilizations.
Greece contributed much to the spread of coinage. Although it probably first began in Lydia (modern day Turkey) around 600 B.C., silver coins became widespread in ancient Greece for a variety of uses such as paying mercenaries, trade, and compensating its citizens.
In the early Roman Empire, loans were often negotiated orally. Instead of interest payments, favors and certain rights were used to compensate lenders. Later, upon the proliferation of written documented loans, formal payments of interest became more widespread. Rome also was able to pioneer public finance to a degree that was not possible in previous smaller civilizations. A strong central government allowed emperors like Diocletian to impose tax reforms and establish a real budget plan.
Early Modern Banks
Some of the early modern banks first arose in the trading centers of Italian city-states. In Venice and Florence in the 13th-15th centuries, banks run by families grew to prominence, one of which became especially well known - the Medici bank. Although the northern Italian city-states were not necessarily richer in resources than the rest of Europe, their central location in trading routes fueled their banks' growth into France, England and surrounding nations. Below are Lorenzo de Medici and the Medici Family Coat of Arms
However by the early 1400s, changing political winds challenged Italian banks as they were banned from profit-taking in England by King Henry IV as well as being kicked out of Paris. In northern Europe, two German banking families rose to power - the Fuggers and Welsers. In northern German city-states, two Dutch brothers established Berenberg Bank in 1590, which is still operational today.
In this period, several developments in the finance industry changed Europe's economy. The cutting edge of banking gradually shifted from the Mediterranean to London and Amsterdam. In these hubs, a new practice called Fractional Reserve Banking allowed banks more flexibility in their lending.
Prior to Fractional Reserve Banking, banks mostly operated on full reserves, meaning that when depositors put their money with a bank, it held close to the full amount of their deposits as reserves in case depositors wanted to withdraw from their accounts. This operates essentially like a piggy bank where if you put 100 coins in, you know they are just sitting there. This was common practice among goldsmiths who accepted deposits of gold and silver coins. But in the 17th century, goldsmiths in London came to realize that it was unlikely that depositors would all come at once to withdraw their funds. This presented an opportunity to profit from the idle coins or cash sitting in the bank's reserves.
Instead of keeping close to the full deposit amount as reserves, let's pretend that bank "A" has a client that deposited $1000 in an account. The bank realizes that at any one time, it is rare for its clients to withdraw more than 10-15% of their funds or $100-$150. This meant that it is reasonably safe for the bank to hold reserves of 25% or $250, and lend the rest out to borrowers to earn interest. This way, banks became more than just piggy accounts with fees, but dynamic and active lending institutions with balance sheets of deposits and loans.
A pattern in finance...risk and reward are twins. Banks can only increase their interest return on deposits by taking more risk. This can be measured by their reserve ratio, or reserves divided by total deposits.
Reserve Ratio = Reserves / Total Deposits
This ratio represents the amount of risk a bank is taking by lending out its reserves. The lower the ratio (the more lent out from deposits), the riskier the balance sheet - especially when depositors all come at once to claim their funds: a bank run. In the US, the Federal Reserve - pictured above - acts as a lender of last resort to ensure stability in the financial system. It also has other roles in regulating the economy and money supply, which we shall cover in future lessons. Let's summarize our example bank "A":
- Deposits: $1000
- Reserves: $250
- Lent Out: $750
- Reserve Ratio: 25%
The 20th Century was one of tumult, progress, tragedy, and innovation. We cannot possibly cover all the important developments in this century, so we shall focus on the Great Depression, the gold standard, and the evolution of electronic payments. An in-depth discussion of the Federal Reserve will be covered in the Economics Prerequisite under Investing.
The Great Depression was a sobering period, but not before a decade of indulgence had run its course in the booming 1920s. Speculation in stocks rose to a fever pitch before the Dow Jones plunged 89% from peak in 1929 to bottom in 1932. The ensuing depression was the worst in US history and sparked a wave of reform in the industry to prevent a similar occurence from ever happening again.
Almost a decade of economic boom had fueled American optimism to excess, and by the late 1920s, this optimism had turned to speculation. However, this alone could not have caused the depression. It was a systematic risk in the industry that exacerbated the negative effects of a stock market crash to an extreme. This systematic risk was leverage by both investors and banks. Investors bought stocks on margin, or with borrowed money. Banks lent money at an extremely low reserve ratio of around 10%. As covered earlier, this means that for every $100 in deposits, banks held only $10 in reserves and lent out $90. When customers came to withdraw funds, banks tried to call loans which borrowers could not pay back. Unable to call their loans, banks did not have the reserves to redeem customers their deposits. This created panic among depositors, faith was lost in the system, and a bank run ensued, causing many people to lose almost all their savings. With a grim economic outlook, banks stopped lending, and a vicious cycle of economic contraction began.
While no amount of regulation can completely rid of economic cycles, it can prevent excess risks in the system. The following acts were passed by Congress to reform the industry:
- Glass-Steagall Act
- Securities Act
- Securities and Exchange Act
The Glass-Steagall Act of 1933 focused on trying to solve the issue that was deemed most problematic in causing the depression - commercial banks taking risks and making big bets in stocks with depositors' money. To prevent this from continuing, it demanded that commercial banking activities (deposits/lending) must be separated from investment, and investment banking activities (mergers and acquisitions, sales and trading). Henry Steagall also agreed to support the Act after an amendment was added to create the Federal Deposit Insurance Corporation, or FDIC, to insure cash deposits during times of panic and bank runs.
The Securities Act of 1933 was created to help the investment community gain access to clear, transparent information about the securities (vehicles of investment) they were investing in, whether as stocks, bonds, or other securities. Whenever a stock or bond is offered, there must be available accurate documentation on important information about the offering so investors know what they are getting.
The Securities Exchange Act of 1934 was created to oversee transactions in the secondary market (primary market - where securities are first issued, secondary market - where securities are traded and exchanged hands). The Securities Exchange Comission, or SEC was created and has the power to oversee transactions, the securities themselves, and the professionals who deal with them, to prevent fraudulent actitivites and manipulation. Next, we discuss the gold standard.
In their early days, the central banks issued paper money backed by gold deposits. This is representative money because the central bank had gold reserves to back the paper currency it was issuing. In 1944, diplomats from 44 countries met to develop an international monetary system called the Breton Woods system, which set gold to a fixed exchange rate of 35 US Dollars per ounce, redeemable by the US government. At first, the system was stable because the US was in a strong financial position following WWII. However by the 60s, the US' share of world economic output had shrunk as European nations recovered and Asia grew in strength. Nations saw that the dollar was overvalued and tried to redeem their dollars for gold. To combat currency volatility, President Nixon consulted Federal Reserve chairman Arthur Burns, Treasury Secretary John Connally, and future Fed chairman Paul Volcker about actions to take. In August 1971, Nixon announced the suspension of the convertibility of the dollar to gold. This was the beginning of the transition of the dollar from a representative money to a true fiat money, backed by faith in the government and central bank.
By the 60s, retail banking was quickly adapting new technologies such as ATMs, and gradually, the late 20th century saw heavy adoption of credit cards and bank cards to fuel the spending power of the consumer. These innovations made life much easier as we ditched fat wallets of cash for sleek new credit cards. However with such ease, convenience, and a consumer culture to edge us on, there would be challenges for society to adapt to as the turn of the century came.
The new millennium began with a wimper as the dot com bubble burst. The Glass-Steagall Act was mostly repealed in 1999 as strong economic growth, globalization, and deregulation took precedence over lingering worries over financial stability. While not a direct cause of the 2008 financial crisis, the repeal was a symbol of the deregulation mood that stimulated the risky behavior of banks leading up to the crisis.
The 2008 financial crisis, still entrenched in the minds of many, was a product of risky behavior not too unlike those leading up to the Great Depression in 1929. While the specific mechanisms were different, highly leveraged banks was a hallmark similarity. Above is a photo of the previous Lehman Brothers building in Times Square before its bankruptcy. Following the crisis, another wave of regulation appeared, and economic stimulus came from the central bank in two forms: low interest rates, and quantitative easing, or QE.
While lowering interest rates to stimulate the economy was a well known tool at the time (easier borrowing for corporations and consumers), QE was relatively untested. QE is the policy by the Fed of purchasing government securities and government backed securities to increase the money supply and lower long term interest rates, both of which stimulate lending. But with any stimulative policy, it cannot go on forever. The Fed is currently in the process of unwinding its balance sheet purchases - its full effects on the economy remains to be seen.
Lastly, as we look to the future, innovation in finance is coming with much promise. Companies like Paypal, Venmo, and Square are transforming the way we send, receive, and spend money. One can only imagine the hassles we will avoid a few decades from now!