Hello and welcome to the first part of this
multi-part-series in which I explain the most basic concepts of our current economic system.
I hope that at the end of this series you will understand the most important macroeconomic
headlines, form your own opinion on how the global economy might develop and how these
developments would impact your own life. Before we begin, a word of caution: I do not
have any formal training in economics and I am an economist only by calling but not
by degree. My actual background lies in mathematics and all information presented here is based
on my own research from various sources. So while I will try to be as accurate, complete
and unbiased as possible, I can not guarantee any of these three things and it is – as always
– up to every individual to be sceptical and to do his or her own research. If you find
any important omissions or errors, feel free to contact me or point them out in the comments
section. In this first part of the series I explore
two questions that are almost as simple as a toddler asking: “Where do babies come from?”
but which are hardly ever asked by any human being of any age much less answered to a satisfying
degree. As it is often the case with simple but fundamental questions, they have the effect
of revealing powerful truths, especially when they are overlooked or ignored by a large
part of society. Those two questions are:
Where does money come from? and
Why is perpetual economic growth so important? I will show that these two questions are linked
in a quite profound way. But before we dive into the subject matter I’d like to invoke
Bertrand Russell. While none of the concepts I will present will be technically difficult
to understand, they might still be hard to believe for some. I therefore ask you to take
Bertrand Russells advice, which is a guiding principle in my life, to heart: When asked what he would like to tell future
generations, he said: “When you are studying any matter or considering
any philosophy ask yourself only what are the facts and what is the truth that the facts
bear out. Never let yourself be diverted, either by
what you wish to believe or by what you think would have beneficent social effects if it
were believed, but look only and solely at what are the facts.” So let’s turn to the first concept, which
will serve as a basis for most of the other concepts. It is the balance. Most people know
that a balance sheet has two sides; that they – as the name suggests – have to be in balance
and that companies usually have to create a balance sheet at least once a year. But
one does not have to have an actual balance sheet to have a balance – in fact we can think
of the balance of an individual, such as you or me, or an institution, like the government
of a country, since the idea of a balance is to list all assets and liabilities of a
certain entity at a specific point in time. How is the balance sheet structured? It has
two sides. Both sides contain various items with cash values. The sum of all cash values
of all items on one side is equal to the sum on the other side. The left side contains all assets that the
entity in question owns. Typical examples are buildings, machines, goods produced and
cash, but also less tangible things like loans to other parties. In short, a financial asset
is anything that is owned and that can be sold for money. The right side is split into two parts: Liabilities
and owner’s equity. Typical liabilities are bank loans or bonds one has issued. In general,
a liability is any kind of promise one made that one would pay a certain amount of money
or deliver a certain good some time in the future. In case you do not know what a bond is – it
is hardly something mystical: A bond is an I.O.U., that is a formal promise. It is being
sold for money in the present and usually promises to repay more money at a later date.
Anyone can create a bond – just take a piece of paper, write a date and a certain amount
of money on it and state that you will pay the owner of this paper that amount of money
at the specified date, sign it and voila – you have created a bond. Now all you have to do
is go into the market and see how much people are willing to pay you for that legally binding
promissory note. That is in fact how many companies and most
countries finance themselves. Often bonds are structured in such a way that instead
of one big repayment in the end, one pays the interest on a quarterly or annual basis
and returns only the original principal at maturity. These payments are called coupons
because in the old days it was actually a part of the original bond which you could
clip off to claim the partial payment. But back to our balance. The only thing left
is owner’s equity – or just equity in short. Unlike all other entries in the balance sheet
owner’s equity is not some fixed value but rather it is the difference between assets
and liabilities. In case of an individual it is also often called the net worth, for
companies it is called the book value (which is not to be confused with the market capitalization
which is the amount of money the market says the company is worth, which is usually higher
because there is a certain value in the “configuration” of the assets that is not reflected by the
balance sheet – but I digress). So equity is the amount of money the owner
of the entity would have left if he were to sell all the entity’s assets and pay back
all its liabilities. A final way to look at a balance sheet is
this: You can look at the right side to find out where the capital came from and on the
left side to see how it was invested or put to use. There are three definitions which often come
up when talking about balances: Solvency, Liquidity and Leverage. To be solvent simply means to have more assets
than liabilities – in other words: To have a positive equity. If your equity is negative
– that is you owe more than you own – then you are insolvent. Liquidity on the other hand simply means that
you have enough cash at hand to pay your current bills. In reality it is usually not a binary
term the way I have defined here, but rather a ratio – but we will simply say someone is
liquid as long as he can pay all parties that have a claim against him at one point in time. Finally leverage is the ratio of assets to
equity. The term leverage is a good illustration of its actual effect. In the real world you
can only lift a certain weight with some limited amount of force – unless of course you are
in possession of a lever. If the lever is long enough you can lift any kind of weight.
In this analogy the weight is the assets while the force is the equity. The term leverage
appears in many financial contexts – sometimes it is also defined as liabilities to equity
– but it always implies that one is somehow using a certain amount of capital to influence
a larger amount of capital. Now let’s look at two simple examples to get
a better understanding of these three terms. This first example is as simple as it gets.
We see the balance of person X who owns one hundred thousand dollars. Perhaps he has been
employed and saved up this money or perhaps his well to do uncle passed away and he inherited
it. Notice that X does not own anything else of value – no house, no car, no cellphone
– according to this balance X is even naked – if he weren’t you would have to find his
clothes in his balance somewhere! But he truly is as free as one can be because he does not
owe anybody anything either. So X has a 1:1 leverage, since nobody has any claims against
him and since he is flush with cash he is obviously liquid and also solvent. In this second example X is not in such a
great position. He still has his one hundred grand but he also owes A and B a substantial
amount of money – more than he actually has! In this example his equity is minus ten thousand
dollars – he is insolvent! But he is still liquid to a certain degree! If either A or
B were to ask for their money back, he could pay up – but as soon as the other one also
wants his money back X will have to admit that he is ten thousand dollars short – he
has become illiquid. So illiquidity is a necessary result of insolvency
simply because one runs out of assets to liquidate to pay ones debts. But one can be illiquid
without being insolvent at all. The problem is that solvency can only be judged if one
can actually take a look at all the assets and liabilities of the entity in question
– and even if the entity itself publishes its balance sheet one still has to place ones
trust in those published numbers – more on that in a second. So illiquidity is somewhat
of an indicator whether a certain entity is financially healthy, that is: solvent – or
not. The reasoning being: As long as someone is able to come up with the money when requested
it just can’t be that bad – can it? An analogy would be: Liquidity is to solvency
as red cheeks are to being alive. Usually if one is alive one has red cheeks, that is,
as long as one is solvent one is also liquid to a certain degree. Also, sometimes someone
is alive but anemic and therefore his cheeks tend to be rather white – even when in excellent
health otherwise. But what usually does not happen though is that someone is dead and
his cheeks stay red for much longer. But exactly that is the case when some economists
speak of “zombie banks”. They are saying that those banks are actually insolvent, but they
are given the appearance of life through liquidity infusions by central banks in the hope that
they would actually recover. But let’s not get ahead of our selves. One last term that is worth mentioning in
this context is the term ponzi scheme. It derives its name from Charles Ponzi who became
infamous for using such a scheme to defraud a large amount of money. In a ponzi scheme
investors are enticed to “invest” their money with the schemer usually with the promise
of high returns – say 20 % interest per annum. But instead of investing the money, the schemer
simply pays his investors their their “dividends” by giving them back their own money and taking
a large chunk for himself of course. Impressed with the “returns” more “investors” flock
to the schemer and he thus “invests” their money just as “wisely”, that is – uses it
to pay off his previous investors. The scheme collapses as soon as money stops flowing in
fast enough or as soon as some of the investors get suspicious how such stellar returns are
actually possible and start to dig a little deeper – or try to pull out their investments
– and find that they are all but gone. Let’s look at an example of a very small ponzi
scheme comprising only the schemer and 3 investors and let’s see how the balance sheets of the
involved parties change over time. The first step for the schemer is getting A to invest
10.000 dollars with him by promising A a return of 2 grand or 20 % per annum. So A gives the
schemer the cash and in its place puts another asset in his balance sheet – a loan for the
same amount. The ponzi schemer on the other hand gains the 10.000 dollars but also a liability
of 10.000 dollars to A. Then, over the course of the year A tells
two of his friends that he found somebody who was willing to pay him 20 % on his money
and both are interested but also skeptical. In the meantime the ponzi schemer spends 2.000
dollars on fancy restraunts – after all he wants to profit from his scheme somehow. At
the end of the year he pays A his two thousand dollars in fake-dividends, which leaves him
with an obligation of 10.000 dollars to A but only with 6.000 dollars in cash. He is
already insolvent. But A is not aware of that, he believes that
the 2.000 dollars he received are actually on top of the 10.000 he should be able to
withdraw. Now that A apparently really made money with his investment, his friends B and
C decide that they do not want to miss out on such an opportunity and also each invest
10 grand with the schemer. The schemer is still insolvent but he is more
liquid than before. Another year passes and the schemer again uses 2.000 dollars to fund
his standard of living. Again he also pays his investors 2.000 dollars each in alleged
dividends, leaving him with 18.000 dollars. Now A decides to pull out his money because
he wants to go on a trip around the world for a few years. The schemer complies and
A leaves the picture. His friends in the meantime did not tell anybody else about the incredible
investment opportunity they found. But seeing how everything worked out for A they are now
more convinced than ever, that their investment is a sound one. So they decide to keep their
money with the schemer for at least another year. So another year comes and goes and another
2.000 are spent on luxurious food and drink. Again fake-dividends are being paid, leaving
the schemer with a meager 2.000 dollars but 20.000 in liabilities. Since he could not
attract any new investors his scheme is on the brink of collapse and when B suddenly
asks to also get his money back he is finally found out and has to run. Now reality dawns on B and C. Even if they
manage to get their hands on the remaining funds they will both have suffered a loss
of 50 % of their original investment and those 50 % do not even include the opportunity cost
of 2 years of forgone interest. So A and the schemer profited handsomely from
the ponzi scheme while B and C had to shoulder the losses. A ponzi scheme is also often called
a pyramid scheme because for it to continue it always takes a new, larger wave of investors
so that previous investors can get their money back. In terms of solvency and liquidity a ponzi
scheme is insolvent pretty much upon its inception but usually liquid right until before it collapses.
It also uses the “I am liquid therefore I am solvent”-makeup to fool its investors.
The most recent example and also the largest known financial fraud in U.S. history was
Bernie Madoff’s scheme. I hope the basic notions of solvency and liquidity
are now well understood. Let’s have a closer look at leverage and its effects.