I've wanted to do this for a while, as I know a few of my family now read this blog and many of them have little understanding of what finance is or how money works. There are several brilliant in-depth essays out there that explain the process in far more detail than I can in my five minute posts. But I'm also aware that the individuals with the least understanding are also the ones least likely to sit and read through a long essay with lots of technical language and numbers (don't beat me).
So here's the bite-size version with pictures!
- Currency -
Traditionally, 'currency' consisted of gold, coins, shells, buttons... more or less anything that could be used as an I.O.U when two or more people agreed to exchange goods or services at different times. It was essentially a store of value that could be redeemed in another place and time and from any other person that agreed to accept the currency.
It didn't really matter what was used as long as it was difficult to replicate and easy to store (for example, apples would be a terrible currency to use as they rot very quickly). Salt was apparently a favourite in the Sahara and East Africa during the Middle Ages. The word 'salary' actually comes from the Latin word 'salarium' (the root word 'sal' means 'salt') which, according to the Oxford dictionary, was the money paid to Roman soldiers to buy salt (my English degree is totally relevant to finance, dad)! People also liked gold and it's still considered valuable today since it's in fairly limited supply and (so far) impossible to create from scratch.
- Banks -
Banks were initially invented as a way for wealthy people to store and protect their gold, buttons, or whatever currency they used. Smaug's lair in J.R Tolkien's The Hobbit is the image I always have when I think of old-school banks. A giant creature defending a huge stash of treasure from people wanting to steal it! A small fee was paid in return for the bank's service and a receipt was given out listing the amount deposited.
Physical currency is only a fraction of the money supply today. Eventually, people started trading the receipts instead of the currency itself, and as a result the banks decided they could earn more by issuing loans backed by the currency they held in deposits. The loans were essentially I.O.Us for I.O.Us of real value.
(This is the point where I like to quote Lewis Caroll's Alice In Wonderland: "You used to be much more...'muchier.' You've lost your muchness.” I think that just about explains finance from this point onwards.)
- Interest -
Things got a bit boring for a while and then the people cottoned on to the fact that banks were making money out of the currency they had entrusted to them. So 'interest' was invented: an I.O.U to pay an I.O.U based on the I.O.U the bank was earning from the original I.O.U in their vaults. Simples. The interest paid to depositors was less than the interest paid by borrowers, so the bank was still earning a living even though the amount of currency they were storing hadn't really increased.
- Inflation -
Considering there were now more I.O.Us in the system than actual goods/services (look up 1931 gold standard for more info), the value of the I.O.Us dropped in real terms as more I.O.Us were printed on the I.O.Us. I found a nice graph for the UK to illustrate my point (everyone likes a good graph):
To clarify; if tomorrow everyone took their money to the bank to reclaim the promised currency at the same time, there would be many many disappointed customers. Money follows the very basic economic rule of supply and demand - if we've got more, it's worth less. That £5 note that bought you 10 loaves of bread in 2001 now only buys you 3. The amount of currency you need to purchase the same value in goods has now inflated. In 1920's Germany during hyperinflation, Reich Marks were literally worthless as currency and there are various reports of people burning money to keep warm as the paper it was printed on held more value as fuel. Inflation is also affected by how difficult the items are to grow, make, find, etc. More I.O.Us or less items mean inflation goes up.
- The 'credit crunch' -
Unfortunately, this system of borrowing on borrowing on borrowing value has expanded even further due to the continued threat of economic system collapse if it ever stops working. When an entire global population is reliant on a system to work, then it is in everyone's interest to keep it from falling apart (regardless of how ridiculous it seems). Runs on individual banks have happened in the past - Northern Rock comes to mind as a recent example of what happens when too many people panic at once and try to reclaim the value of their I.O.Us.
The same thing occurred on a global scale during the so-called 'credit crunch' a few years back. Governments and companies lend I.O.Us to each other as well as the banks, and if too many players ask to exchange the I.O.Us at once then it causes a knock on effect. Everyone suddenly panics that there isn't enough to go around and starts to demand their share of the value. I personally don't believe the issue was ever a lack of I.O.Us, as the banks have the ability to create an almost infinite amount of digital currency these days. It was likely mass confusion over the redeemable value of the currency, causing all the major players to halt production of any more I.O.Us of I.O.Us. Which, if you think about it, is very silly considering all the original I.O.Us no longer hold the same value they did to begin with! If that didn't make a lot of sense, don't feel bad. Most economics undergrads struggle with the concept. Fortunately, the very clever people in charge printed a lot more I.O.Us, which will TOTALLY fix everything (lucky us).
- Value vs Population -
Most of the money in circulation today is a giant ocean of I.O.Us with a few tiny islands of actual value (land, food, water, materials, workforce, etc) dotted around. I imagine it looks a bit like the universe, with lots of dark matter and a few clusters of stars and planets gradually drifting apart. Oh yeah, pretty deep stuff for a Saturday afternoon! Here's a nice picture of part of the universe:
In the UK, the average debt per household is around £13,000 and the average in savings about £3,300 (www.aviva.com/media/upload/Family_Finances_Report_July_2013.pdf). This doesn't include mortgage or car loans. That's a lot of I.O.U-ness (sorry, I said there wouldn't be lots of numbers). According to mainstream media, we are now recovering from the recession and well on our way to sustained growth. The stock market is thriving once again, unemployment is falling, business is growing. Yet the amount of real value redeemable per person is shrinking due to inflation.
There are various ways of calculating wealth. I'm old-fashioned so I tend to consider mainly those things that a human needs to survive on this planet - shelter, food, heat, etc. Anything else is of secondary importance and useful only as a store of value to trade for the really valuable items that keep us alive and healthy (basically, more I.O.Us).
So let's start with land. Land is quite useful for growing food, providing materials and space for shelter. Or it can even be used as shelter itself. Ask any military bod. In the UK, there are 260+ people per square kilometre of land (going by the World Bank figures). This is increasing by the year. Less land to go around, and that's assuming the land is shared out equally to begin with - it isn't. In fact, you're not even allowed to fight people over it like they did in Medieval times, for... reasons (which I think is completely unfair)! I'm not going to discuss house prices in any detail here, as I believe they are artificially inflated right now due to government intervention. But I would expect the natural costs to be on the increase regardless.
Food is another important one. Intensive farming methods have kept prices lower than they would otherwise be. However there has still been continual inflation in this area (if you're not used to graphs, bear in mind this one shows the percentage increase in price, not the price itself):
Fuel - again, your I.O.Us buy less fuel today than they did last year or the year before that. I mentioned rising utility bills in a previous post:
So... the I.O.Us are worth less and less actual value. The best way around the issue for the average person, as far as I can see, is to focus on obtaining value first and foremost. Collecting I.O.Us only benefits you when the potential redeemable value is increasing (when I started this blog I was just seeing how much money I could save up for the sheer hell of it, but these days I want to own a house/land outright and plan to put that money into something of value when I have enough). I'm not a Marx groupie, but he was right when he pointed out that the ruling class own the means of production. Everyone needs to eat continuously during their lifetime and there's a good reason that the richest people own the most land (and for the record, a mortgage does not constitute land ownership - until you pay it off, the bank is technically the owner). Sort out the basics like land, shelter, food production, textiles for clothing, fuel, tools, and then worry about flashy cars, swimming pools, and the latest fashion.
n.b. Alice In Wonderland is a brilliant novel full of amazing advice that everyone should be forced to read at gun point. How can you argue with wisdom such as 'if I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn't. And contrary wise, what is, it wouldn't be. And what it wouldn't be, it would'? Very sensible words!
Also n.b. This is all just personal opinion. I quit my Economics degree in year 2 because I thought a lot of it was very clever-sounding b*llocks that further complicated an already over-complicated system. I get paid a pittance to organise other people's money now, but still find economics and finance interesting. By the time I reach 30, I hope to have discovered the world's largest chocolate coin.