Category Archives for "Finance"

Section 2.1 – What is Money?

In the 16th century when the Spanish and Portuguese privateers looted millions of pounds worth of gold from the Incas and the Aztecs, they carried it back home, imagining that it would make their country rich. But it had the opposite effect. In reality they suffered from rampant inflation which undermined the functioning of their economy and both countries went into a decline from which they had still  not recovered in the 20th century. This neatly illustrates the point I made in Section 1.4 that money is not the same thing as wealth. If money is not wealth then what is it? The definition of money is that it is “an item or record that is generally accepted as a payment for goods and services”. Since those goods and services are forms of wealth, money can be regarded as a token which represents a claim on wealth. Seen in that light, it is clear why carrying gold back to Spain and Portugal did not increase the wealth of the country. Gold in that context can be regarded as a form of money, but no new goods or services were created by this activity. Therefore what happened was that there was more money chasing the same quantity of goods and services, and therefore the prices of those items rapidly increased. In every inflationary situation there is an element of the quantity of money available outstripping the supply of items to purchase with it. This was clearly seen, for example, in Germany in the 1920s when the Reichbank literally printed banknotes in ever greater quantities and ever larger denominations – possibly with a deliberate  intention of devaluing the currency to ease the intolerable burden of the war reparations which had been imposed by the victorious forces of World War I at the Treaty of Versailles.

Money is now such a pervasive aspect of our lives that we take it for granted, and we also take for granted the current form of the monetary systems within which we operate. Let us look at how this system has developed over time, and the various forms which money has taken at various times in history. Although we are currently going through a transition towards an entirely electronic system, the most familiar forms of money are coins and banknotes, but over time all sorts of objects have been used as money: seashells, bones, tobacco leaves, cigarettes, and so on. But the form of money that has been in most widespread use over the entire course of human history and pre-history is grain – wheat, barley or rice. This would have been the near universal form in which tribute was paid to local warlords, as we discussed in Section 1.6 on the origins of governments. And indeed it would have been the most common form of currency for the payment of taxes right up until the end of the middle ages. This is illustrated by the widespread appearance of tithe barns which are found all over the country. Looking at this example, it is clear that the lords of the manor did not imagine that their form of social structure was likely to change any time soon.

The local landowners would collect their taxes in the form of grain to be stored in the tithe barn, and gradually depleted over the course of the year until the supplies were replenished at the next harvest. The landowner would pay his guards and soldiers and his servants substantially in grain and he would also use grain to purchase items from craftsman and artisans. The tenant farmers themselves would also often pay for goods and services from their fellow villagers with grain, beyond what they required to feed themselves and their families. Grain was therefore serving the principal function of money, which is to act as a Medium of Exchange. The same function could be served by any commodity which has an intrinsic value itself and is reasonably durable. The use of goods to facilitate trade in this manner is called Commodity Money.

According to basic economic teaching, money has three functions: one, as just noted, is that of serving as a medium of exchange. The second function is as a Store of Value. Clearly this example illustrates that function too: when the tenant farmers have delivered the due portion of the harvest to the Lord of the Manor, and he has stored it in the tithe barn in August, it will remain there until it is extracted either for his household consumption, or to use as payment at some time later in the year.

The third function of money is to serve as a Unit of Account. For example, suppose the farmer has no spare grain in June, but he needs the blacksmith to shoe his horses: he could make a promise  to deliver a certain quantity of grain at a later date, after he has harvested the current crop.  This arrangement would be described as “delivery on account”.

In the ancient world, from about 5,000 years ago the three commodities most frequently used as money were gold, silver and copper.  The reason was that these were chosen was that all three metals could be found in a raw form on the surface of the Earth in limited amounts, and all three were regarded universally as being of value. Silver and copper were far more commonly used since the supply of gold was much smaller. There were several advantages to the choice of these metals rather than agricultural products for trading purposes:

  • They provided a consistent quality – one pound of silver is completely equivalent to another (subject of course to an assurance of purity), whereas one bushel of wheat may differ significantly from another.
  • They are stable and durable over time. Gold does not corrode at all, and silver and copper only marginally, in contrast to food products which may get eaten by pests or spoiled by fungus.
  • They are not in demand for consumption, as agricultural products obviously are.

One point about commodity money worth noting is that when used for its utility function, it ceases to be money. That is 100% true in the case of  foodstuffs – obviously if part of your wealth is in the form of wheat, and you eat it, you no longer have it to spend. It is partially true in the case of precious metals: if you make your silver into a bracelet or a candlestick for instance, you cannot both enjoy the use of the object and spend it in the course of trade. However, it will always have at least the intrinsic value of the weight of silver. It may of course have a higher value if the trader you offer it to appreciates the functional or aesthetic qualities of the object.

Around 2,500 years ago various rulers realised that they could facilitate trade by striking gold, silver and copper into coins of a standard weight and a guaranteed purity. In return for the convenience of not having to weigh ingots of arbitrary size, and for the confidence of the quality of the metal, traders were content to accept a slightly smaller metal quantity than the face value of the coin. The difference between the two was known as the Seigniorage and provided a profit for the ruler. This coined form of metallic commodity money became an almost universal standard for trade until the issue of Representative Money became common in the sixteenth century. Coined commodity money remained the normal form of payment for day-to-day transactions of modest size until the early 20th century, when it became progressively replaced by Token Money.

Until 1914, trade in Britain was carried out with copper pennies which contained about a penny’s worth of copper, silver shillings that contained twelve pennies’ worth of silver, and gold sovereigns that contained £1 (twenty shillings) worth of gold. At the outbreak of World War I gold sovereigns were withdrawn from circulation and replaced with banknotes. Over the next few decades, the silver coins were withdrawn and replaced by ones made of a silver-coloured nickel alloy worth much less than the face value of the coin. When Britain changed to a decimal currency system in 1971, the ‘New Penny’ (now 1/100 of a pound rather than 1/240) was a much smaller bronze coin. Some years later the coins were reduced to a smaller size still, and now the ‘bronze’ coins are made of steel with a thin bronze surface plating. Thus all physical money currently is token money.

Representative money consists of a document certifying the claim to a specified quantity of some commodity money (usually gold or silver). It originated when customers deposited gold with goldsmiths for safe-keeping and were issued with a receipt that would entitle the bearer to withdraw the gold from storage. Initially a customer who wished to spend some of his gold would return and withdraw it, but over time traders became accustomed to accept the certificate itself as a means of payment. Goldsmiths developed into bankers, and realised that they could issue more banknotes than value of the gold that they were holding, on the principle that it was unlikely that all the customers would come to claim their money at once. As recently as the 1960s, Bank of England notes used to say “I promise to pay the bearer on demand the sum of one pound in gold”, even though it wasn’t strictly true, since Britain had come off the Gold Standard in 1931. Now the notes just say “I promise to pay the bearer on demand the sum of ten pounds”. If you think about it for a moment you will realise that this is a completely meaningless statement. What are they offering to give you? Another ten-pound note? Two five-pound notes? In other words paper money has also – like coins – become token money. This type is sometime called “fiat money” from the Latin word fiat, which means ‘let it be’.

But notes and coins make up only a very small proportion of the money in circulation – most of it is Bank Money which has no physical presence at all, and consists of entries in the ledgers held by the banks. How this is created, and how this is related to the derisory value of your pension and the insane prices of houses will be the subject of the next segment in this thread. The creation of excess money by banks is correlated with inflation – the erosion of the purchasing power of money – which has been a persistent feature of the economies of all developed countries over the past sixty years. Inflation amounts to a swindle perpetrated against those holding assets in the form of money in favour of those holding other tangible forms of wealth. It also disadvantages those who have less power to adjust their incomes to take account of the reduced  value of money, compared with those who do have such power. It robs savers of the value of their savings, and allows borrowers to repay debts with money that is worth less than the original value of the loan. Clearly a currency which is undergoing inflation fails to serve two of the three functions of money described above; it is not satisfactory as a unit of account, nor as a store of value. The issue of inflation will be covered in greater depth in a future section within this thread.

This is Section 2.1 of my forthcoming book The World in 2100: What might be Possible for Humanity? within the ‘Finance’ theme. When we return to this thread, the next topic will be Banking and Stockbroking in a Sane World. 

If you haven’t already done so, you can register to receive a free review copy just before it goes on general sale later this summer. Registering will also take you straight to Chapter 1 – The Foundations which will give you more idea of what the book will cover.

Section1.2 – The Great Pension Robbery

Section 1.2 -The Great Pension Robbery

A great many people reaching pension age today have had a nasty surprise. They are finding out that the pension they get is nowhere near what they had been expecting. Those approaching it have a sinking feeling that it is not going to work out as expected.

For example, let me tell you about my own experience. In summary, I was given to expect that I would get a pension for of around £14,500 a year for life, and what the plan actually yields is about £2,400 a year. Almost everyone I talk to is getting similar shortfalls.

I still have the letter that the salesman (sorry, I mean the financial advisor) sent me when I took out my pension plan in 1984. What he said was that by paying £70 a month I could expect my retirement fund to be £161,727.00 by the time I retired. This was assuming a 12% growth rate, which he said was conservative. This fund would provide a £40,431.75 lump sum, and leave £121,295.25 to buy an annuity which would give me an income for life of £14,555.00 a year, assuming an annuity rate of 12%.

It’s worth pointing out the £14,555 would have been quite a substantial income in 1984 – equivalent to about £43,000 a year today according to the official inflation figures, which are hopelessly understated anyway. Even though wouldn’t be worth nearly as much today, I would still be delighted if I were getting £14,000 a year from the pension now.

But the reality of the situation is this: when I got to retirement age I found that the fund hadn’t grown by anything like the 12% he had suggested. Instead of the projected £160,000, it had £58,000 in it – giving me a lump sum of £14,500 and leaving £43,000 to buy the annuity. But the real kicker was that the annuity rate is nowhere near 12% now – it’s somewhere around 5.5% at best, and so the actual income that I get is only about £2,400 a year!

The financial people just shrug their shoulders and say “Well that was only an estimate! We didn’t guarantee that it would work out like that.”

Let’s have a look at how these pension schemes are supposed to work in theory… In fact it’s exactly the same process as any honest form of wealth generation: there is an accumulation phase and a payout phase.

  • In the accumulation phase you pay a portion of your earnings into a fund that is invested in income-earning assets.
  • All the income that those assets generate is re-invested back into the fund, so that it grows much faster than it would by your payments alone, by “the miracle of compound interest”.
  • In the payout phase, the income that the fund generates is paid out to you, rather than being re-invested.

For pension schemes, it is normal practice for the fund to be invested in an annuity for the payout phase. This is like a life insurance policy in reverse; instead of taking your monthly premiums while you are alive and paying out a lump sum when you die, the provider takes a lump sum at the start and pays out a monthly distribution to you as long as you live. This generates a slightly larger income than if you had just invested the capital yourself in a “safe” investment (such as government bonds). However in that case, your capital would have remained intact at the time of your death for distribution to your heirs. In the case of the annuity, the balance goes to the insurance company when you die. If you live less than the average expected time, it’s a very good deal for them! And I’m sure they have worked out the sums so they don’t do too badly, however long you live.

All this is a re-run of the Endowment Mortgage Scandal, which came to a head in the 1980s. In the late seventies and early eighties, most people buying houses were persuaded to take out endowment life assurance policies that were intended to pay off the house purchase loan at the end of the agreement, and also produce a surplus bonus payment. In the late eighties it became apparent that the estimates of the investment performance had been ludicrously over-optimistic, and the payouts were going to be nowhere near large enough to pay off the loans.

It’s not only personal pension plans that are running into trouble. People who are relying on company schemes which promise 2/3 of the final salary for the rest of their lives might be in for a nasty shock too. The funds that the companies have been paying into are running into exactly the same sorts of problems that the personal ones are showing. They may be paying out as agreed at the moment, but further down the line the cupboard might turn out to be bare.

There are a lot of issues raised here which I’ll discuss in much more detail later, for example:

  • Just look at the ridiculously precise figures he quoted me, given the speculative assumptions that the calculations they were based on. Isn’t it absurd that he quoted the final value of the fund to eight significant figures, when it turned out to be over 63% off at the end of the day? (I call this the delusion of spurious precision – this is a whole subject in itself, that I’ll deal with in a later section:  How to Avoid Number Bafflement, within the ‘Patterns and Numbers’ theme). That wasn’t his fault – he just punched the numbers into his computer and quoted the figures that it spat out (as no doubt he was trained to do by the company). And how successful would an advisor be who said “You might end up with about 160 grand, give or take 100 grand”? But he would at least have been honest!
  • Was the 12% a year growth rate he suggested completely fanciful? Given that the UK stock market index went from 1040 in 1984 to over 6400 in 2013 (a compound growth of over 7% annually), and that most of the blue chip companies paid annual dividends of about 4%, I would have been able to get around 11% annual growth myself by simply investing directly in a cross-section of major industrials and re-investing the dividends. Where did the rest of it go? It went into the pockets of the practitioners of the financial system.
  • The 12% annuity rate he quoted was at least representative in 1984, but how come it has gone down to 5.5% or less now, with such disastrous effect on the pensions of people now reaching retirement age?
  • Why has inflation reached such epic proportions in the last few decades? And who wins? And who loses?

This is Section 1.2 of my forthcoming book The World in 2100: What might be Possible for Humanity? within the ‘Finance’ theme. When we return to this thread, the next topic will be The Nature and Meaning of Money. 

If you haven’t already done so, you can register to receive a free review copy just before it goes on general sale later this summer. Registering will also take you straight to Chapter 1 – The Foundations which will give you more idea of what the book will cover.