Thursday, 7 August 2008

Financial system basics

Well, right now we are in the middle of an economic crisis, a credit crunch, the start of the next depression, a housing bubble going pop and a whole lot of other economic difficulties that I will have a look at going forward.

This time, however, I am going to talk about the basics of the financial system, specifically the answer to this question -

What gives pieces of paper with dead presidents, monarchs and other various famous people any value?

When you think about it, the trading of bits of paper with people printed upon them (they aren't even naked!) shouldn't really have all that much value. You can't eat them, you can't write on them all that well, you cannot do very much with them at all.

So..why so valuable?

First of all- taxes.

You have to pay your taxes or some rather nasty things will happen to you (assuming you are caught of course.) You have to pay your taxes using the "legal tender" banknotes of the country that you are living in.

The simple act of threatening people gives fiat money, legal tender, paper currency or whatever you want to call them their value. They are, in effect, "get out of jail free cards." Without taxation paper currency has no value.

A simple analogy is this -

A large, heavily armed group of men are demanding that you provide them with pictures of someone who used to lead their gang. Luckily for you, there is another group of men called "bankers" (who apparently have nothing to do with the first group) who are willing to loan you the pictures (at interest) if you provide them with collateral in the form of promised future labour, your assets such as cars, houses and so forth. There is also a third group of men who are giving out pictures of ex-gangleaders in exchange for a days work, these people also seem to be an entirely different group to the gang which is threatening you.

So...you pledge your assets or work for a day to acquire the pictures of old gang leaders and give them to the heavily armed gang, who seem pleased and tell you they will leave you alone for the rest of this year but will be back next year for another payment of pictures and every year after that.

As soon as the heavily armed gang leave you, pictures in hand, they drive straight around to the workmaster and give him some of the pictures, and then drive to the banker to give them some of the pictures so that when you need some more you can pledge more of your assets or do more work for yet more pictures. This is happening to all of your neighbours, all of your friends, to your family all at the same time and so it seems kind of ..well..normal. People trade the "get out of jail free cards" amongst themselves even, because they have value - what's more important than your liberty and your unmolested health?

Now, I don't know about you, but this looks a lot like slavery to me. It's more complicated than an outright master/slave relationship but it pretty much amounts to the same thing.

The second thing you can do with the paper is to cancel debts as far as the heavily armed gang is concerned. They have a court system where one of their number settles disputes by using the gangs might on one party in a disagreement (usually the one who has least to offer the gang.) If you offer the gangleader pictures to pay a debt, then the courts will back you up even if the other person wants some other substance instead. All legal means of restitution are lost if the paper currency is refused.

So, people accept them for this reason.

Again, I don't know about you, but this doesnt seem to me to be the most equitable arrangement. it looks a lot like one man getting another to work for him for free by using force.....which is again a kind of slavery. It's almost an embarassed slavery though, not the old, open kind - a veneer of legitmacy has been placed over it and the obvious coercion has given way to a game of plausible deniability where it could even be argued that one hand really doesn't know what the other is doing.

I doubt that the average worker in any of these spheres (or the average tax/debt payer) has this global view of events. Higher up the food chain the truth will be known of course.

And so we have this blog, within which I shall aim to put how our systems work as simply as possible, without terminology or jargon as far as possible and hopefully by using easy to understand analogies and stories to illustrate what actually goes on.

Thank you for reading and have a good one!

10 comments:

Anonymous said...

Injin,

Nice to see you got your own blog, I'll be interested to see how it develops.

Can you clarify this for me, it was the only section I didn't get on the first read, and am still unsure;

The second thing you can do with the paper is to cancel debts as far as the heavily armed gang is concerned. They have a court system where one of their number settles disputes by using the gangs might on one party in a disagreement (usually the one who has least to offer the gang.) If you offer the gangleader pictures to pay a debt, then the courts will back you up even if the other person wants some other substance instead. All legal means of restitution are lost if the paper currency is refused.

Ok, the gangleader pictures are the paper you refer to earlier in the paragraph? If so, what other substance would the other person want?

Mac.

Injin said...

That would guess on what they had lost, I would imaghine.

If you had totalled my car, I might want a replacement car delivered, but the court system allows you to hand me pieces of paper instead.This lead to further demand for fiat that otherwise wouldn't be there. Equally I might want paintings, gold etc if they had been lost or damaged.

The ability to give money or a more generally accepted good in place of some rare or even unique item IS useful because not all items can be replaced, but the blanket allowance gives the fiat paper another source of demand and therefore value it otherwise would not have.

A ford escort is easy to replace, a morgan aero isn't a piccasso is hard to replace, a picasso print isn't.

I should have also mentioned fines in my post, I might amend it later. Basically fines for littering, smoking in a pub, watching TV without a licence all boost the value of the currency, which might explain the incredible numbers of new laws passed in the last ten years that lead to licencing or fines, eh?

Anonymous said...

I see. Insurance companies would be involved in most cases but the outcome would be to offer an amount of money equivalent to the item in question.

Never thought of fines being a tool for increasing currency value, not sure about that one, but I do see how they encourage the idea of force in relation to the 'heavily armed gang'. All part of the same process?

Mac.

Injin said...

The fines and licences do also perform the function of punishment and regulation - it's a definite win/win for the courts and government.

One problem is that almost everyone sees some regulation, law and punishment as a required part of civilised life and so the heavily armed gang has latched onto this idea and subverted it for various reasons.

In one o fmy fuure blogs I'll be describing how fiat money is actually designed to stp trade, to cease action and make the easy difficult.

Peace,

Injin

Joe Blow said...

legal tender isn't the word you are looking for, it's currency.

you have to pay taxes in the national currency, different forms of of the currency may or may not be valid legal tender for paying those taxes.

otherwise, good luck with the blog.

Anonymous said...

"I should have also mentioned fines in my post, I might amend it later. Basically fines for littering, smoking in a pub, watching TV without a licence all boost the value of the currency,"

Wouldn't this potentially increase circulation velocity thus causing inflation and erosion of currency value?

Nice blog by the way, should be some interesting discussions

Injin said...

Legal tender distinction is correct, I'll amend going forward but leave the existing posts as is.

Thanks for the correction.

----------------------

It does increase velocity, but the balance between scaring people into using the paper and not doing too much so it retains it's value is a tricky one.

It's more important to scare the right people - as the bankers are currently finding out, running the scam on people with nothing and no wit to make anything costs them more than they can take in.




Thanks for the comments :)

Joe Blow said...

I'm not so sure that increased velocity always leads to inflation.

for example, the airlines, which have been benefiting from increased velocity lately, are now suffering from lower sales/lower velocity.

their answer is that they have to RAISE prices, since when they always had full flights, they needed less per passenger, but as things slow down, they will have to increase their margins per head.

I understand the argument that increased velocity causes increased demand, which SHOULD raise prices, but you also have to factor in commoditisation of product that is allowed and efficiencies of scale that come with the higher numbers of sales.

the more of a thing you sell, usually the cheaper it becomes.

so increased velocity should lower prices in some cases.

Injin said...

Bankers don't sell more, they loan the same thing more often. Lending the same pound or dollar to 97 different people doesn't make any more dollars.

It does dramatically increase demand for that dollar though - 97 people need to get hold of it to repay their "debts."

As people default, demand drops off. Someone who loses their home and goes bankrupt suddenly doesn't need thousands of pounds or dollars a month to make repayments. The only reason someone would default in this way is if their assets were worth less than the money they owed, of course.

As people repay, demand drops off. A man who repays his credit cards and loans doesn't need money as much.

Saving then results instead.

With money, increased velocity is deflationary AND lowers prices.

Anonymous said...

Hi Injin,

I've read your comments for many months on HousePriceCrash. Please keep up with the blog and keep talking.

I'd hate to see the people on HPC who cannot agree with you get you so angry you leave.

Please keep posting. For the sake of the Truth.

Kind Regards

Q