Finance studies the way in which liquid resources, cash and cash-like stuff, moves about in a broader economy, and – if all works well – gets to where it is needed.
Finance is a branch of economics, and so as you might suspect is concerned with “supply” and “demand.” But it is concerned with a very particular branch of each. Consider the cash that some people have saved. We’ll call them the Jones’. They’ve put cash away somewhere – in a safe, let us imagine, or in a pillow case – where it is immediately available to them should they want it. Consider also that there are other people and institutions who very much want the use of that cash. These others may have a very restaurant and a distinctive brand, but may need a new infusion of cash in order to expand the restaurant, perhaps making it a chain.
In this case, the idea naturally arises that the Jones’ money might be lent to the restauranteurs, as equity (in which case the Jones’ expect a share of profit) or as debt (in which case they’ll expect a stream of payments inclusive of interest.) The Jones’ cash represents the supply of something that the restaurateurs demand. The economist will ask his usual questions. How much will the restaurateurs have to promise the Jones’ to get the deal done?
The usual notions of supply and demand are in full force here. If there is a lot of unused cash sloshing around in the economic system, it will be lent from one party to another more cheaply than if cash is rare. That is, the price of money rises and falls inversely to supply. Looking at things on the other side, if there have recently been sharp business failures and there aren’t a lot of restaurants in a position to expand, then such money as is lent out will be lent out more cheaply than if the economy is humming and everybody is full of optimism and profit projections. That is, the price of money rises and falls directly with demand.
But you will find the words “supply” and “demand” used only rarely in the book that follows. This is because finance proper begins there, it doesn’t dwell there.
What you will find here is a straightforward discussion of the various instruments, institutions, and functions that mediate between the Jones’ and the restauranteurs. In politics in the U.S., the contrasting terms “Main Street” and “Wall Street” convey the general idea. “Main Street” refers to the general economy aside from the finance segment, and this general economy includes both savers such as the Jones’ and businesses or individuals looking for cash. “Wall Street” refers not so much to the southern tip of the island of Manhattan but to the most prominent of the mediating institutions whose function it is to get the cash from one set of hands to the other – or, rather, to the hands best capable of doing productive things with that cash.
The world of finance so understood includes the activities of banks, insurance companies, broker-dealers, stock exchanges, mutual funds, hedge funds, commodity pools, pension funds, and day traders. All are engaged in the great higgle-haggle that gets money from savers to entrepreneurs, and that defines the rates of return. As we’ll discuss in some depth in what follows, this transfer of money can take the form of a loan, or of an ownership stake in the financed business, or of an instrument derived from one or the other of those two basic transactions (that is, a "derivative"), or it can be a derivative of both debt and equity (that is, a hybrid). Everything is possible with sufficient ingenuity.
Here’s where things get tricky. We as observers of this messy but ingenious process of mediation have to acknowledge, I submit, two points. One the one hand, the mediation between savers and entrepreneurs is itself useful and valuable work. In principle, those who do this job deserve compensation for it. The worker is worthy of his hire. On the other hand, the system is subject to dysfunctions. In plainer language, it can be messed up, and lead to unhappy consequences. That is something in which we all have an interest.
Every conscious and reasonably intelligent adult in the 21st century ought to have some familiarity with some of the issues facing the world of finance, and some of the issues that this world poses for the greater world. Further, it is best if you get a sense of these issues without having to wade through unnecessary jargon or partialities. You hold in your hand, or possess within your eReader, the right pages for this purpose.
The book is divided into three parts: a static explanation of how the mediating institutions and instruments work; a dynamic explanation of what has happened in this world in the course of a roughly 20 year period beginning in 1993; and a look at three Big Ideas that are the legacy of centuries past and that will continue to have a big influence on the near-term (and at least medium-term) future. First, then, we will create a model of the financial world. Then we will set that model in motion to show how it lumbered about through a recent 20 year period. Then we will look forward, on its behalf and on our own.
You might well ask at this point: why does my sample 20-year period begin when it does?
Well, these years are recent as I write, the finance controversies thereof fresh in mind (mine and, perhaps, yours) and the materials for their study easy to find. Another important consideration: insofar as we can pinpoint such a development at all, it was around the time 1993-94 that a new phenomenon called the internet, or the World Wide Web, began rewiring the mechanics of the buying and selling of financial instruments.
The story of what happened next is a fascinating one, and I doubt that any other 20 year period I might have chosen would shed as much light upon the underlying model of how the financial world works, or would set you, my reader, up in a more complete way for the discussion of legacies that follows.
The three legacies with which we shall conclude this book are: the nation state; Islam; and currency. One word here about each: the nation state (a form of political organization considerably larger than a city, yet smaller and more homogenous than an Empire) has come to seem in recent centuries almost like the Natural Order of Things, like gravity. But it isn’t. It is not natural, not particularly orderly, and there is reason to doubt that its reign as the dominant means of organization on this planet will last forever, or even for another century or so.
Islam will last a good deal longer than that. Indeed, I am as certain as I am of my own name, of the following two propositions: Islam will still be the predominant religion of the peoples of large tracts of the earth in another century; and it will be a minority religion, perhaps the religion only of a very small minority, in other large tracts of the planet at that time, too. This won’t change. The question is: how do those different tracts work out peaceful coexistence? Our understanding of finance will have a lot to do with the way we answer that question.
Finally, currency. That stuff that savers save and borrowers desire is generally printed or minted by a nation-state or (in much of Europe now) by some union of several nation-states. Is that inevitable? If the nation-state is to lose its own dominance, then this sort of nationally designed currency will presumably lose its. What might replace it?
But it will be a long while before we get there. Let’s begin at the beginning. For our purposes this means: let’s start with something that even the casual reader of news reports knows, and working out from there. What this casual reader, know about finance as I’ve defined it above is that sometimes savers put their cash to work by using it to buy stock, that is, equity in those corporations that have had themselves listed on one of the public exchanges.Once such a company, known as the issuer, sells a share of stock, thus giving the buyer a piece of the action, the benefit of its corporate success and some of the risk of its corporate failure, this buyer is of course free to re-sell. That is what the major exchanges, such as the New York Stock Exchange, and the cumulative indexes, such as the Dow Jones Industrial, are on their face all about, these secondary trades that don’t directly involve the issuer at all.
Actually, though, these secondary trades and the prices at which they take place do very much concern the issuer. There are several reasons for this concern. I’ll list four:
1) Many executives and employees of the issuing company will be heavily invested in the stock.
2) The company may even be using the stock and options as a key method of compensating employees and attracting new talent.
3) Higher stock value on the exchanges translates into the ability to issue further equity, or to sell bonds for that matter, as needed.
4) Lower stock value creates the threat of a take-over, because it turns the company into a bargain for somebody else: take-over is often feared by those who are presently in control and hope to remain so.
The rise and fall of a corporate stock’s price is a matter of some moment, then, from a lot of points of view. We will start out first chapter by asking: why do stock prices move?
Just two more items of business separate us from our proper beginning. First: who are you? Second: who am I?
The intended reader of this book is a follower of the news, in whatever medium you find convenient. You are intelligent and have at least a high school education. If you’ve been to college, you most likely pursued some field other than economics, finance, or applied mathematics. Perhaps you majored in political science, or sociology, or art history, though you may have dipped into economics, taking a course or two. I will presume little or nothing in that line. You are open-minded, or you wouldn’t have picked this volume up or read it even this far.
Who am I? I’ve been writing for all of my adult life. I’ve been writing for a living for much longer than I’ve done anything else. And much of this work has consisted of keeping tabs on the world of finance, especially the funky little-regulated world known as “alternative finance,” consisting of hedge funds, commodity pools, and their wannabes.
I’m also the bearer of a lot of opinions: some well-informed, some probably not. I haven’t tried to hide my opinions from you in anything that follows, but I haven’t made them the point, either. This book is a guide for explorers of what will be for many of you a new world. My goal isn’t to tell you what to think of the world. It is to display the contours and some key features thereof.
So: let’s get going.