The Financial Jigsaw – Issue No. 9

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

We have been exploring the global financial system generally as an overview up to and including Issue 8; see here: https://www.theburningplatform.com/2018/07/07/the-financial-jigsaw-issue-no-8/  In this Issue No. 9, we begin our journey into the various jigsaw pieces which make up the whole image.  We can conjecture that so far we have been getting the pieces out of the box, sorting them and getting the edge pieces in place ready to begin the overall jigsaw picture.  We have picked up a piece which says ‘MONEY’ and it is this item which we will examine in depth in the next set of Issues.

MONEY

To those who use well what they are given, even more will be given, and they will have abundance.  But from those who do nothing, even what little they have will be taken away.

Bible: New Living Translation – 2007- Matthew25:29

So says the good book and how true it is today for 95% of the world’s population.  Even in our ‘first world’ of abundance we witness relative poverty every day.  How can this be when there is so much production and wealth exhibited far and wide?

Who or what guides this complex system by rewarding that small percentage of those who command 95% of the wealth?  To begin the answers to these questions we need first to understand how our economies work and how money makes it all go around.

Where it all started

In the beginning, life for the average human, first and foremost focused on acquiring food and water without which none of us would survive for very long.  To do this efficiently we have been programmed to work cooperatively in groups, first in small families, then tribes and finally cities, states and great nations.  All our efforts depend on cooperation by trading useful items between each other and then between groups and finally nations.  This is the basis of our world today; it’s all about trade.

In early times a system of barter was used, in theory at least, enabling an exchange of goods to provide for the necessary variety of foods and materials to make for a more secure and pleasant lifestyle; this is known as trading and has been man’s major occupation since time began. Barter, however, didn’t last long, if at all.

In reality, all exchange began with credit and it only takes a moment to think about how this took place.  One person would say: if you help me build my house I will deliver you some food from my garden.  This is in fact a credit contract and has been the basis of trading ever since mankind began his journey towards civilisation.

Inter-tribal battles and wars were common because it is easier to steal goods from others than do the work necessary to “grow one’s own”. Soon it became clear that ‘might was right’ and the strong and healthy began to rise above the others and accumulate a greater proportion of the pool of vital resources.

These leaders dictated and controlled the terms and conditions of trading which eventually became encapsulated in the ‘Laws of the Land’ mostly to the advantage of the leaders and their compatriots: the “Powers That Be” in that particular world time and space.

Along with (barter-type) credit trading came the need to find a convenient means of exchange; instead of trading a sheep for vegetables, for example which was impractical, the traders could use an ‘intermediate’ unit of exchange which would be commonly accepted by all concerned. Although the very first method of exchange was that of credit, which we will cover in a minute, the next iteration became what we now know as money which served merely as a means of exchange in the first place but later became a method of storing wealth.  So what is wealth?

As we progress in our journey many more questions like this will arise and the answers will gradually emerge as the jigsaw picture begins to form.

Gold & Silver become ‘real’ money

In the early stages various local materials were used for money by general acceptance of the parties to a trade.  For example, salt was used in areas where it could be mined (which is where our term ‘salary’ comes from when the Romans used it extensively; shells were common in pacific islands and in rain forests, beans and other rare items were incorporated into local exchange systems.

Finally, because of its many superior attributes, gold (and silver) eventually became the main source of both storage of wealth and a monetary unit for exchanging goods and keeping a record of account.

As time passed and trade expanded to encompass many countries, methods of trade began to develop specialities.  There were merchants who specialised in various goods which could be exported around the world.

A problem arose from the need to ensure that payment for goods would be made on time following delivery after some months of shipping across borders and overseas.  This required the creation of an intermediate body which would take on the risk of extending credit to the purchaser during the passage of the shipment until the goods arrived safely in port.

From early days a system of money changers had arisen whereby owners (often merchants) of gold, now a recognised medium of exchange and wealth, were able to deposit their gold in secure vaults owned by the money changers; these are known as deposits, just as you and I would make a deposit into our bank, except now paper and computer digits have replaced gold for daily use.

In exchange, the money changers wrote out a slip of paper, a receipt to the merchant, detailing the amount of deposited gold and its value after charging interest and fees.  It was not long before merchants began paying for their goods using these receipts by endorsing them payable to the seller in settlement of their debts; they became a form of currency and from this the idea the bank note became established and in common use.

Fractional Reserve Banking & Issuing Credits

It didn’t take long for the money changers to figure out that they were holding much more gold than was likely to be claimed by the owners at any one time.  To increase their profits they started issuing more notes than they had gold on hand knowing that it would be unlikely for all their customers to want their gold back all at the same time.

This worked well and of course relied on the trust of the merchants that their ‘money’ was always available in the vault, on demand, should they want it. These are known as ‘on-demand deposits’.  The system of loaning out more than the deposits you have on hand is known as “fractional reserve banking” and we will cover this in future issues about banks.

At the same time merchants who wanted to buy goods from overseas (imports) needed to issue a notice to their suppliers that they would be paid once the goods arrived.  Of course the seller would not necessarily have faith in the merchant-importer that he would be good for settlement of the bill.

The merchant therefore went to his money changer asking him to issue his own notice to the seller promising to pay for the goods once the merchant had accepted them in good condition on arrival at the port.  Of course the seller, knowing that the money changer had plenty of gold on hand, would be comfortable about taking his promise to pay.

In other words the shipper had security of knowing that he would definitely be paid.  This is the method of credit that we use today and thus Commercial Banks arose which now became the main intermediaries involved in all this trading and payment of exports and imports; some of the documents used today are known as Letters of Credit and Bills of Exchange.

Without this system of trust and faith in principle, with all the attendant mercantile laws which evolved to govern it, our food and goods which you see in the supermarkets and stores could never happen.

Thus the banking system has enabled our modern world to provide all the abundance that we see around us!  Who would have thought it?  So we owe the banks a great deal of thanks for what they have delivered so far. However, the next question must be: what has gone wrong?

Why are the banks now stealing much of our money (deposits) without notice as happened in Cyprus in 2013?  The answer lies in how the banking systems have evolved, especially during the last fifty years.

Technology has made such massive progress that the banks have taken advantage of instant, ‘global’ trading and settlement; the system has become highly complex and totally divorced from the real world of basic trading in the goods and services of the past.

Managing debt – from cash to credit

It is clear that if we are to learn more about how our money is being used by the banks we need to know a lot more about banking systems in the modern world.  Your bank manager will have spent many years learning his profession which includes not only finance but also economics, accountancy, statistics and English law as well as the skills of written and verbal communication, personnel management and many other allied subjects.

I seek here only to describe the most important aspects of these subjects which affect all of us generally.  Sadly our education system fails miserably to make sure students have at least a working knowledge of modern-day money management and particularly debt management systems.

The financial world evolved since before the 1950s from a cash-based society to one of credit – the “live-now-pay-later” consumer economy – which developed in the 1960s with its attendant credit card systems and extension of credit to all and sundry without consideration of the ability to repay the loans with interest.

Loans of money extended to credit-worthy people became necessary many centuries ago because of our agricultural society’s need to grow crops over time and deliver the produce later at the end of the season.  The farmer needed to buy seed and use equipment and labour in order to produce crops therefore he had to borrow money in advance before he could sell his crops and recover his costs plus profit.

Thus the farmer was ‘investing’ his capital and labour into the land in order to earn a living but at some risk.  His ‘return on investment (RoI)’ is his profit but this must come after he has paid all his costs, taxes and interest on any loan or advance of money.

The capitalist production system

You will notice that four key terms (jigsaw pieces) have entered our story: Capital, Labour, Land (these three are known as ‘Factors of Production’) and additionally an important one: interest. Capital may be thought of as money but may also be machinery, plant and equipment and indeed land.  This is the basis of our ‘capitalist society’ where private capital is applied to land, raw materials and labour in order to produce finished goods.

But of course we ask who has access to all the money?  Yes – the banks!   Therefore our capitalist society relies on the banks to issue loans in order for production to take place – without it everything stops!  And we know that this operation relies on trust without which the banks will not function.

Now we know who controls everything from the base of the pyramid we can look more closely at how the banks operate and make their profits out of their customers’ use of labour and land during the production process.

However, the banks have a problem.  It is easy to lend to merchants because the loans are backed by the merchant’s goods which are to be delivered having already been shipped and documentation (commercial paper) having been lodged with the bank. No risk then for the bank because they will only send the money to the overseas seller when the goods arrive in good condition at the port.  This is known as security or collateral.

The banks who engage in this sort of finance are first and foremost known as ‘commercial banks’. They have been active in various countries since before the 13^th century when Italian banks operated by families of merchants set up shop as financiers, for example the Medici family in Italy and later the Rothschild and Rockefellers et al of whom you may have heard.

Nevertheless the farmer is a different case because he has not yet even planted his seeds which of course he has to buy first.  This means that the bank is being asked to advance a loan over several months to the farmer without being certain that he will actually deliver and repay the loan.

The bank will ask for some form of security to back the loan in case the farmer fails to repay because his crops might fail or a whole range of other risks come into play.  In this regard, just as the merchants importing their goods might suffer loss due to storms or pirates, so the farmer could lose his crops through no fault of his own due to weather, fire or war.  Thus the need to offer insurance arose at the same time as the finance was agreed.

But now the farmer has a problem because he may be a tenant farmer with no land of his own to use as security for a loan.  This is where markets come into our jigsaw puzzle and this will be covered in later Issues of our Financial Jigsaw.

To be continued next Saturday

Author: Austrian Peter

Peter J. Underwood is a retired international accountant and qualified humanistic counsellor living in Bruton, UK, with his wife, Yvonne. He pursued a career as an entrepreneur and business consultant, having founded several successful businesses in the UK and South Africa His latest Substack blog describes the African concept of Ubuntu - a system of localised community support using a gift economy model. View all posts by Austrian Peter