Wednesday October 13th 2004

Finance : first lecture (part one).

Introduction

This finance course is organized into two semesters. For convenience, the first semester is called "Managerial finance", and the second semester "Corporate finance". Most textbooks call the whole thing "Corporate finance". I shall get some of my material from two textbooks:
- Ross, Westerfield and Jordan, Fundamentals of Corporate Finance, McGraw-Hill/Irwin
- Brealey and Myers, Principles of Corporate Finance, McGraw-Hill/Irwin

These textbooks are at the MBA level and therefore we shall cover only part of them, because we are in a second year undergraduate program. I will follow my own organization and sometimes it will come from one of the chapters of these books. Secondly, these books use very little mathematics, to the point that they are sometimes more confusing than if they had used some. Remember that mathematics is only a language to express clearly and precisely what we mean. Properly and simply used, it doesn't have to be esoteric. Thirdly, these books begin with two or three chapters describing what is a corporation. For the moment what we learned last year in accounting about corporations is sufficient.

I will also get some of my inspiration from
- Paul Wilmott "Quantitative Finance", John Wiley & Sons

This book has a European style of presentation of finance, as opposed to the American textbooks. It incorporates an elementary presentation (mostly heuristic) of some of the mathematics required to study finance. But it is an advanced textbook using stochastic calculus and going deep into the subject of options.

A good understanding of accounting is a prerequisite to be in a good position to study finance. Happily enough this is our case.

Topics of this first lesson

Here are the topics I shall cover in this lesson. Today is a rather substantial lecture. I shall introduce casually many of the concepts that will keep us busy all year long.

- Money and value
- Accounting of firms
- Assets, those which "work" and those which "don't work"
- Money, again. Money doesn't work. We shall see what is meant by this. Somehow, money is, at the same time, very useful and totally useless. Money by itself doesn't produce any money. I have some in my pocket. Here is 20 euros. If I keep it forever, it will stay like this. (It may even loose all value like this 100 DM banknote.) If I really want to transform this into more money, I have to do something with it.
- Purpose of finance
- Project investment
- Financial investment. These are two slightly different types of investments.
- Money, value, time and risk
- Interest rate
- A security
- Its price
- Its profitability
- Risk again
- Probability
- Random variables
- Games with a die, to begin with our understanding of probabilities
- Two securities S and T

Finance is the study of investments. We shall see more precisely what is meant by this.

Basically, we could say that the purpose of finance is to take some value today and to manage to make it bigger in some future.

In fact, more surprisingly, it will be : "How to make it bigger now ?". But we shall discover this little by little. It is not necessary to have a clear view of this right now.

Stated another way, the big purpose of finance is: I have some value now, how to make it bigger?

That is a fairly simple objective, isn't it ?

We shall see that value always, ultimately, comes from human work and from need. To create value the two basic ways are:
- work
- exchange the value we own into another value, that - we anticipate - will be worth more in some near future. This always boils down to some sort of speculation.

First of all, we have to go back to "what is value?".

Money is traditionally described, in all textbooks, as having three roles;

1) It is a unit of measurement of value (of any tradable goods or services having value), in a given community. For instance in the euro zone we use the euro. I can put some monetary price tag on this chair: something like 40 or 50 euros I suppose.

2) It is a means of payment. If I have a debt to you (that is, I'm a debtor of yours), I can pay you with money. If the money I use is "legal tender" in our community (our country - if we live in the same country), you cannot refuse it. And my debt is extinguished. And yet I have only given you pieces of paper, signs ; it has no intrinsic value (usage value) on its own.

It is the state authorities that decide what money is legal tender and what is not. For instance, in all the countries of the euro zone we changed the legal tenders two years ago. That is why my 100 DM banknote is now worthless. State authorities manage their money. In China the state forbids to deal in yuans outside the country, and the exchange rate with other currencies is as strictly controlled by the Chinese authorities as they can.

3) It is a means of reserve. If, for some reason, I cannot spend the money I earned, I can always keep it in my pocket, or accumulate it in a vault, or even deposit it in a no-interest-bearing checking account. It will keep its value. Only "more or less" as you know. This is a big problem. But for the moment we do not need to worry about that.

This is the traditional way to describe what is money. Those of you who will go into a deeper study of money will discover that there is much more to the story than this.

Money is a bit like the blood of the body. If you look at the quantity of blood passing through a vein during one day, you will measure dozens of liters. Yet, as we know, it is not possible to take out, say, 10 liters, of course, because we only have 5 liters of blood in our body. This image applies to the money in an economy. It also applies to currencies, and in particular to "foreign funds entering a country" : $10 billions in money can enter a coutry during one year, yet it is possible that such quantity is found in the country, at the end of the year, only in the form of debt due. The naive image of "foreign currencies entering and leaving a country" like the surf is profoundly misleading. Double entry accounting applies to countries as well as to firms. (More technically it applies to consumers, producers, commercial banks, the central bank, the Treasury, and the Rest of the World. For each transaction involving money, or financial value, or concrete value, between any two actors there are two movements, two accounts modified in each accounting system, etc... Sometimes imbalances will be corrected by inflation, sometimes by a decrease on the labor market, sometimes by other corrections.)

Many people, including political activists, don't figure this out very well. They will say things like : "Why ! If the governement gave firms 150 billions over the last ten years in tax rebates, this money must be somewhere !"...

When we study money, not only do we have to make the usual distinction between flows and stocks, but also we have to pay attention to the distinction between money and other types of value. Another image is this : money is like small wheelbarrows to transport big sand piles from one place to another. The size of the wheelbarrows (even added together) does not have to be as big as the size of the sand piles. The image does not correspond exactly to the mechanisms of money (we would have to introduce other things brought by the wheel barrows as well), but everybody will understand that we don't want to stock the wheel barrows !

These are only simple images to prepare our intuition. We shall study all this in depth next semester. It is not our point today. Remember just this : money is the medium to transport value (from one owner to another) or to transport or modify debt in transactions, and it does not always behave like our intuition, at first, suggests.

I take this opportunity to tell you that the 2004 Nobel prize of Economics was given, a couple of days ago, to Kydland and Prescott, two specialists of money, more precisely two specialists of the management of money by central banks.

Money is only one aspect of value. Remember the balance sheet of a firm at any date t : the asset side is a list of all the values owned by the firm at the date t. Customarily we list them as this, from bottom up :

- money, that is cash, in the form of banknotes, in the till, and money at the bank in a bank account (that is in credit, viewed by the bank, and in debit viewed by us). The bank account is a checking account bearing no interest, not a saving account. In France the banknotes (and coins) represent only about 15% of all the money circulating in the form of banknotes and bank account balances. In the middle of the XXth century, the ratio was 50-50.

- debtor paper : this is no more than trade credit we granted to our clients, because we trust them, and this helped us sell them our goods.

- stocks : this is value again. This value begins to "work". Here is an example: if I have in stock garments that will be in fashion next year, then there are in the process of gaining value. (I told you: creating value sometimes boils down to speculating. If you can foresee that something will gain value, because of the evolution of tastes or needs, and if you are a bit quicker than other people you can enrich yourself. Right after WWII, the father of an acquaintance of mine purchased all the stamps that the US authorities prepared for France but that De Gaulle refused to use. He sold little by little these stamps over several decades. And his son inherited a great estate from his father speculation.)

- fixed assets: machinery, land, plants, etc. These assets clearly "work". When they are properly employed, they transform people's work into value that not only pays for their work, but also enriches the owners of the machines.

Up until the 1960's French people used to dislike checks. And before that, in the XIXth century, they even disliked banknotes. There are historical reasons for this. After the death of Louis XIV, in 1715 (this is not so long ago: my great grand father, who died just before I was born, was born closer to Louis XIV than to today), the State was broke, due to the four wars Louis had waged. The Regent was offered by a shrewd Scottish financier, named John Law, to set up a bank in France. The bank issued notes against money (there was plenty of gold in France, due to Colbert mercantilist policies, but not in the Treasury), and it provided the Regent with plenty of money. But, as often happened in those early times of banking, it issued too much notes, and in 1720 the bank went into a catastrophic bankruptcy. (Details on John Law.)

A similar experience happened to us during the French Revolution : the revolutionary authorities needed money, among other needs to fight the allied foreign countries who wanted to help our king to get back its full power (because our revolution threatened them as well). The government  issued "Assignats", "guaranteed" by Church properties that the Revolution had confiscated in 1790. We also cut our king's head to be on the safe side. But again the government issued too much notes, and within a few years the Assignats lost just about all their value. So French people have long been weary of paper money, and preferred gold.

Napoleon, who is not someone I totally recommend, restored French money, by defining the Franc germinal, worth 5 gr of silver at 90% grade (we were still using silver, when the English had already mostly swiched to gold. But in those times they were also confronted to unconvertibility because of.... the French revolution and the Napoleonic wars. This is a long story worth studying.) Franc germinal was a stable unit of money in France until the outbreak of WWI.

In France, one could change one's banknotes into gold until 1936, and in the US that was true until 1971 (with some technical limitations). As you can see, that is not so long ago that "money was backed by value". Whether this is useful or not is the subject of the so-called Bullionist controversy that agitated England in the early XIXth century, and that is still quite an interesting and not satisfactorily resolved question. There is still plenty of room for other Nobel prizes in Economics, particularly in the field of money.

Do not think the situation has much changed. In the last 25 years the French government debt went from 90 billion euros (computed by dividing the actual figure then, expressed in French Francs, by 6,55957) to 1000 billion euros. Inflation, over the same period of time, was about 2.3 , that means that 90 billion euros of 1980 are "equivalent to" 207 billion euros of 2004. Therefore the French government debt was multiplied 5 fold. The pieces of paper bearing promises to pay back the money it borrowed from lenders, by the French government, are called Treasury bonds (TB). They are not banknotes like those issued by John Law, but they are likely to become as worthless because there are too many.

The US government debt, as of October 2004, is $7400 billion. I.e. the US government issued for $7400 billion of pieces of paper promising to pay them back (Treasury bonds and equivalent) to people who lent it that value in real dollars (obtained from trade and other activities) These "people" are economic agents of all sorts all over the world, in the US and elsewhere.

Japan holds about $700 billions of these pieces of paper, and China around 200 billions. Here are some figures from two years ago : US_treasury_bonds. (And for more explanations : http://bonds.yahoo.com/ir_bd2.html )

Money is one form of value, a very special one because modern money has no usage value of  its own.

Keeping money does not fulfill the objective of Finance, which I have stated to be : transform value into more value.

This is the first paradox we have to remember about money (we shall see many paradoxes about money) : money is great to have (to purchase things, to feel rich...), but you don't want to keep much of it, because it doesn't grow.

There is one special situation where people want to keep their money. It is called a situation of "liquidity trap". It is when it seems quite likely that money invested in "safe" treasury bonds (that is lent to the State) will actually loose its value soon. That is the case when interest rates are very low and likely to increase soon.

So we see that value can take many forms : the form of money (in which case it doesn't "work") or other forms. The asset side of a balance sheet lists all the values owned by a firm. It's called its assets. Since all these, as a whole (not elements by elements), must belong to or be due to owners and creditors, there is a liability side that lists the liabilities. (Since we know accounting rather well, I can express myself casually, as I do here. We know in great details the machinery to prepare a balance sheet. You will discover that, even after years of familiarity with balance sheets, we still uncover new aspects of the power of this representation of the firm, devised eight centuries ago and expounded for the first time in a manual by Luca Pacioli in 1494, illustrations by Leonardo da Vinci !)

Remember: thinking of what is in a firm is always thinking of its assets. It is somewhat concrete. You can see them. Liabilities are a bit more abstract. (It's like viewing a bicycle, and thinking of whom it belongs too.) If you need a brief recap of Accounting you can read the beginning of my course on the subject here : Accounting.

The operations of a firm :

The elementary operation of a firm is called a transaction. A firm carries out many transactions every day.

A transaction is always an exchange of value with the rest of the world, two movements of value, at the same time. There is no such thing as a transaction, one part of which takes place today and the other part another day.

For instance when we lend money to someone, we actually buy today a piece of paper. It is one complete transaction.

And later on, another day, there is another transaction : the borrower gives us back our money plus some interest. It is also a complete transaction. What leaves our firm then is the piece of paper we give back to the borrower, or we may tear it.

A transaction involves two movements of value at the same time, but not necessarily, as we know, any movement of money. For instance a sale on credit involves no money. Yet there is value out (some goods) and value in (debtor paper).

As far as the amount of values are concerned, we may distinguish three types of transactions :

1) Those where, for our firm, Value in = Value out. This is the case of a purchase of machinery for instance. 100 000 euros leave our firm (money or promise) and a machine enters our firm.

2) Those where Value in > Value out. We make a profit. For instance suppose we sell for 100 euros goods, recorded at 70 euros in our stocks. On the asset side the stocks decrease by 70 euros and the cash (or the debtors) increase by 100 euros. The whole assets increase by 30 euros, with no increased liabilities to external creditors. In that case, on the liability side, it is the retained earnings that increase by 30 euros.

3) And those where we make a loss : Value in < Value out  :-(

Note that in the first case, where for us Value in = Value out, this is usually not the case for our supplier of machinery. For the supplier, normally, Value out < Value in.

So we see that :

Value is not the same for everyone ! (Except for money. And even then...)

(This is contrary to the Thomist view that the value of something ought to be the quantity of labor "contained" in it.

But the Thomist view is only wishful thinking, or a useless definition.)

In Accounting, a transaction is always at one time (not several). This will still be the case in Finance.

In Finance as in Accounting, we make a rather casual use of the word "money".

We take for granted that we know what we mean : banknotes and bank account balances that enable us to draw checks without asking our banker for credit. But remember that banknotes, when they appeared in the western world, in the XVIIth century, were at first paper certificates of gold deposit. And until recently, 33 years ago in the US, we could get our gold back.

Even gold, by the way, it is debatable whether it has value of its own, or it is just signs. Ok, gold is nice looking, and nice to own, but it doesn't grow, it does not transform itself into more value as time goes. In that respect it is like paper money : only signs. But one can claim that it provides pleasure, and in that respect it has intrinsic value. (But then paper money...)

Note that as of November 7th, 2004, the dollar is loosing value against the euro. And note too that gold is gaining value...

There is more to money than appears at first. It is fun to study. The field is still wide open for new ideas. In fact, it is in dire need of a new paradigm, because the current views have been agitated for a long long time without shedding new light on the problem of how to manage best the monetary means of a community in order to spur prosperity and fairness.

Purpose of Finance (more elaborate statement) :

It deals with spending money into projects in order to create value, more value hopefully than the money spent at the outset.

This statement involves several concepts:

- the concept of money (the basic form of value)

- the concept of time : in the words "in order to create" in some future...

- the concept of risk : in the word "hopefully".

Finance deals with money, time and risk.

Some people like to say : "Finance looks at the time value of money". Beware : this sentence fills the mouth and makes its speaker sound very smart, but in fact nobody with a clear mind can understand what it means, if he or she doesn't already know what finance is about. Don't be fooled by great sentences or pompous declarations that you sometimes read in the newspaper. More often than not the author doesn't really master his subject. Otherwise he would be much clearer.

I hope I showed you that Accounting is not unclear. It is complex at times, but it is very clear. The same is true of Finance. If you read a book and you don't understand it, assume it is the book that is confusing.

Money is full of paradoxes, but - in the approach we follow in this course - it is very clear. One paradox is that money is desirable, and yet when we have some we don't want to keep it, because keeping it is a waste of value which we could gain.

In fact, one of the functions of the financial officer of a firm is to always make sure there is no more money in the cash and bank accounts than is needed for short term payment purposes. Last year, I explained to you that you should never run out of cash ; this year I explain to you that you should not keep too much cash !

Investments :

Firms make investments. They invest money. They do this in order to grow.

Except for certain small entreprises that really are just the working tool of a few persons, firms which maintain a steady size are exceptions.

The logic of firms - the way they are run in the western world - is not to stay steady (to distribute, for instance, all their income as salaries and dividends which would be transformed into consumption). It is to grow.

Of course, there are investments just to maintain the production tools, to compensate depreciation. But I'm talking about investments to grow : investments into more production capacity ; investments into R&D to expand markets, or to lower product or production costs ; investments into a large advertising campaign ; investments in training of the work force, etc.

All these are called physical investments. They are also called, equivalently, investments into projects.

We shall distinguish two different types of investments :

1) physical  investments, as described above, and

2) financial investments.

This second type is easy to understand, if we remember how the liability side of a firm's balance sheet is structured.

The capital account records the shares of stock which the firm issued at the time of its foundation (or when it looked for extra capital). These are pieces of paper (or equivalent electronic recordings) owned by people, the owners of the firm. These shares entitle their owners to a proportion of the dividends which the firm gives out, when it gives out some. (Firms don't always pay dividends. For years after it raised a capital on the stock market, in 1986, Microsoft paid no dividends. It began for the first time in 2003 : article.)

When you decide to buy shares of a firm (either newly issued shares, or shares traded on the stock market), you actually invest money into assets which have value (you hope) but are no longer money. Of course, you expect your investment to create more value for you than the money you had at first. Otherwise you would not change your money into shares.

Such an investment is justified either by the expected stream of dividends, or by the prospect of a capital gain when we sell back the security, or by both. That way we make our money "work".

When we invest our money as just described, we are making a financial investment.

We try to transform value into more value. And we cannot do this by just keeping our money.

Any purchase of promises to get future payment (Government bonds, corporate bonds, shares of stock, even the purchase of foreign currencies) is a financial investment.

They are analysed essentially in the same way project investments are. The study of the way to analyse them will keep us busy the whole course long.

The graphical representation of a simple investment :

A simple investment, in a first approach, can be thought of, over a period of one year, as this : we have today a certain sum of money P in our pocket. P stands for "price", the price of the promise we shall buy. We exchange it today for a promise S to get a higher sum of money X in one year. S stands for "security", it is the customary name we give to a promise written on a piece of paper, particularly when there is some collateral guarantee attached. X is the future sum of money promised.

Sometimes the future amount X is a well specified figure. And sometimes not (we shall see this later).

To begin with, we consider a security S, sold for a price P, and which promises a specified, well defined, amount X in one year.

For instance, we pay today $100 to someone to buy a security from him, and we agree that he will pay us, in one year, $106.

We say, in this case, that our investment will earn an interest of 6%.

Investments with no risk :

There is a type of securities which have no risk. These are short term securities bought from governments of large prosperous countries. Said another way : if I have dollars and I lend my dollars for a short period of time to the US government (it is possible to buy such securities, they are called US Treasury bills), I encounter just about no risk not to get my money back plus interest.

Note that these are financial investments. There is no investment in physical project that have such zero risk.

If the person (or the economic agent) to whom we lend our money today is 100% trustworthy, i.e. if we are sure we will get our money back plus interest, then nowadays, in mid October 2004, in the US the investment described above, yielding 6%, is a pretty good deal for us !

Indeed, nowadays, in mid October 2004, the US government, who is the safest borrower in dollars one can think of, only pays 1.75% (on a yearly basis) for short term investments.

So any other rate than 1.75% is either a bad deal for us or for the borrower :

- if we lend our money at less than 1.75%, we would be better off lending it to the US government,

- if we lend it at a higher rate than 1.75%, our borrower could find someone else willing to lend him at a lower rate than us (anyone that was going to lend to the US government).

In other words, nowadays, it is possible to lend money to the US government for a short period of time and then get it back. We get it back plus a little more (nobody would accept to lend money for a while and not get anything on top for it). The little more is called the "interest". Measured in percentages of the initial money it is called the "interest rate". At the moment the risk-free interest rate in the US is 1.75% (on a yearly basis).

"On a yearly basis" means this : if you lend money, say $1000, for just one day, you will get tomorrow your money back plus

$1000 x 1.75% / 365 = 4.8 cents

This figure of 1.75% is decided by the head of the Federal Reserve Board, Alan Greenspan, and his team.

Note, these figures are true for dollar investments in the US. For investments in another currency, for instance euro lending to one of the governments of the euro zone, the figures are slightly different : at the moment the rate for risk-free short term investments in the euro zone is 2%.

For the euro zone, the decision to set the risk-free short term interest rate is taken at the European Central Bank, in Frankfurt, by Jean-Claude Trichet and his team.

Remember, we want to keep some money for payment purposes. But aside from this, any money we have we want at least to make it "work" in the safest possible way, and that is to lend it to the governments of large countries using the same currency.

Governments borrowings :

For the past two or three decades governments of rich western countries have become big borrowers. They are considered to be risk-free borrowers.

Examples :
- we saw earlier the US government has a current debt of $7400 billions.
- the French government has a debt of 1000 billion euros.

We saw that the US government is considered the safest possible borrower of dollars. This is because the US economy has been, for the last 60 years or so, the most "powerful" in the world.

This has not always been the case : for the two centuries preceding WWI England was the most powerful country on Earth, and its currency the pound (even when it was in the form of banknotes) as well as its promises were the safest currency or promises. But in those times governments were not as big borrowers as today. They only borrowed temporarily to finance wars.

US governments bonds are "safe", and they better be, because foreign states hold  $1800 billions of such promises : details. (source : http://www.ustreas.gov/tic/ )

Let's use some yardsticks to have an idea of how big are these debts :

- The US government debt is equal to 2/3 of the entire wealth created in one year in the United-States.

- The same is true in France. The French government debt is about 2/3 of the entire wealth created in one year in France.

This entire wealth created in one year in a country is called its GDP (Gross Domestic Product). There are three standard ways to account for it (to arrive at the same figure) Details (source : http://www.quickmba.com/econ/macro/gdp/ )

We live in a world where big rich countries have put themselves in financial and monetary jeopardy.

Borrowings by developing countries :

Beginning in the 1970s, developing countries also began to borrow a lot, including their governments. They are much less safe than the US or France.

In fact, in 1982, Mexico could no longer face the payments required by its promises (its debt, mostly to large western banks) and it was lead to "default" on its debt. Then its debt was "reorganised" (rescheduled) by the IMF. This was the beginning of the so-called Third World debt problem.

The history of default by sovereign states goes back as least to Philippe II of Spain around the beginning of the Eighty years war.

The Third World has known many financial crises since then, the most important one was the "Asian crisis" of 1997/98, which began in Thailand.

Argentina has been in chronic financial crisis for decades.

We shall talk more about all this in the course on International Finance, next semester. (For more information, including videos : http://www.pbs.org/wgbh/commandingheights/lo/countries/index.html )

Surprisingly enough, when a country encounters difficulties paying back its bonds, it may be a good deal for a shrewd financier to purchase them at a devalued price, because then, if the economy of the country improves, the bonds you just purchased may gain much value. For this reason, last year,  Argentina itself was offering to purchase back its bonds at a quarter of their face value !

Everything has a value ! As long as you believe it will generate some money...

Historical rates :

One thing to remember : the present day risk-free short term interest rates are unusually low, between 1 and 2% in the US. Twenty years ago when you were born they were unusually high..

Here is a picture of the rates on a slightly different kind of bonds in the US over the last two centuries :

It is not exactly the risk-free short term interest rate, but the story is the same. You should memorize this chart.

This chart is one illustration of the deep changes the world financial system experienced over the last thirty years.

- from 1800 to 1875 : steady around 6%

- 1875 to 1900 : the so-called "Great depression" of the end of the XIXth century (don't mix it up with the Great depression of the 30s). This depression of the end of the XIXth century is "explained" by the end of the first industrial revolution in the western world, when all countries were essentially equiped with railways and first generation factories (the steel factories had less work, prices declined, some large banks went bankrupt, etc.). The economies of large western countries were restored when new growth was created by the electrical and the automotive industries, and also by the armament of large countries and empires that lead to WWI...

- a peak during WWI because the US financed the world war

- a slight peak right before the stockmarket krach of Thursday 24 October 1929, then a decline during the Great depression of the 30s that bottomed out at the end of WWII

- then a steady climb, first back to "normal" rates, and then way past them.

- the 50s, 60s and 70s were the period of construction of the "welfare state", a social organisation which provides many benefits to the populations (health care, comfortable retirement money, many free public services, etc.). All these benefits have to be paid for - some people tend to forget this -, and now in many western countries we experience financial difficulties that are the consequence of trying to maintain the welfare binge of the period 1950 - 1980.

- in the early 80s, Margaret Thatcher in England and Ronald Reagan in the United States decided to strongly fight inflation and to reduce government direct intervention into the economies of their countries.

The 80s and 90s are, over most of the world, the decades of selling off of state owned industries, and deregulation of many industrial and financial activities. (details)

This is not finished. For instance at present in France the government wants to (partially) privatize Electricité de France (EDF), and there is a debate going on whether it is a good decision or not.

- finally a great dip toward today's very low rates, and the present worrisome world financial state.

The risk free short term rates of major countries :

Today interest rates paid by risk free large borrowers for day to day borrowings (computed on a yearly basis) are these :

They are defined slightly differently from above, but it is of no concern for us here.

(October 14, 2004. Source : Le Monde)

Of course, the US borrow in dollars and pay in dollars ; the euro zone borrows in euros and pays in euros : the UK borrows and pays in pounds ; Japan borrows and pays in yens ; and Switzerland borrows and pays in swiss francs.

The relationship between interest rates, quantity of money, inflation, and prosperity :

Many great minds have been trying to explain the relationship between interest rates, the quantity of money, inflation and the prosperity of a country.

No theory, at the moment, is convincing. The two main schools that were in opposition over the last half century are :

- The monetary school (an offshoot of the Classical school) : their leader is Milton Friedman (born in 1912), professor at Chicago University (see also Friedman). He is an advocate of not "playing around" with the short term interest rate, like the Fed does to try to adapt to the state of the economy. And he recommends to maintain the quantity of money available in the economy on a predictable steady course. (Source : http://www-hoover.stanford.edu/bios/friedman.html)

- The Keynesian school : their leader was John Maynard Keynes (1883 -1946), the most famous english economist. He was an advocate of important government intervention, through large taxes (or borrowings...) and then large public expenditures, to try to help the economy recover, when "market forces" did not lead spontaneously to prosperity, as was the case during the Great depression of the 30s. Under Keynes recommendation states somehow become entrepreneurs, but entrepreneurs that are not constrained by market forces. Whether this is good or bad in the long term for the economy of a country is a hot debate. (Source : http://cepa.newschool.edu/het/)

(There are also a variety of even more planned economy schools : neo-marxian, regulation, etc.)

The current view among most economists nowadays is that Keynesianism is probably bad. But some other people say : "Who cares about economic theories, what matter is social welfare and fairness". Then the first ones reply : "But your way to try to reach social welfare and fairness leads to poverty !"

We have a whole year to gain knowledge and experience to build our own opinion.

The objectives of Economics :

The objectives of Economics are

1. to understand the conditions of prosperity and fair distribution of wealth in a community, and
2. to determine what laws and what governement actions are best suited to help reach prosperity and fairness.

Since the end of the Ancient Régime, two centuries ago, the economic workings of most modern societies is based on the production and exchange of work to buy and consume goods and services, produced by work within firms. This is done via the medium of money and credit (a subtle form of money) to operate exchanges. And the banking system plays an important role in this too.

Classical Economics, following Adam Smith, says that this system works best when left to itself ("laissez faire, laissez passer"). The law of supply and demand via the "Invisible Hand", described by Smith, always takes care of filling out lacks, and moderating excessive increases. But everybody can feel that this theory, despite its intuitive attractiveness, is simplistic and mistaken. Complex dynamic systems are rarely optimal and stable. For those who like theorems (in a simplified setting though) there is the result of Sonnenschein-Mantel-Debreu that establishes the fallacy of Smith reasoning. The end word will be given in some future by nonlinear mathematics. See for instance the book Thinking in complexity by Klaus Mainzer.

Governments can act on two levers to influence and try to correct these workings :

1. they can tax or borrow money in larger quantities than what is needed for strict public expenditures, to spend it into activities that lag in the free system (Keynes pointed out that there is a "multiplier effect" to such public spending, like for any spending for that matter...)
2. they can act on money and credit, via the short term interest rate, via the quantity of money injected by the central bank in the system, and via various other regulatory means at their disposal (including currency control, like is still done today, for instance, in China).
3. (And of course there is all the apparatus of laws and regulations, and redistribution of tax money, etc.)

But money is an elusive concept. Probably some concept of "money + credit" will turn out to be a better measure of the exchange capacity of each economic actor. Sometimes having more money gives more purchasing power, and sometimes the value of money gets corrupted. Why ? The reasons are many : for instance there may not be much to buy, or the power of some economic players to set the value of what they sell may be excessive (OPEC...). The "value of money" is essentially set in each private exchange. And, in a transaction, each actor has his own set of personal values, including that of money. Public control over "the value of money" is limited. It is a complex "intensity parameter" in the complex economic system.

Firms invest to grow and produce more wealth. They do that by trying to maximise profit. But profit too is an elusive concept. Classically, it is analyzed as the remuneration of risky capital. And probability theory is used to study this remuneration (the profitability of securities and investment that we will study all year long).

One aspect of the complexity of the system is this : firms are naturally encouraged to increase their productivity. This means producing the same output with less work, and therefore with less expenditures to buy work (mind you, this involves the value of money...). But work is the way consumers get their money, that enable them to buy goods... So productivity is not a panacea. Countries then distinguish between competitive industries (for instance, the automotive industry in Japan) and sheltered industries (for instance, the retail distribution sector in Japan), and say that what matters is the productivity and competitiveness of competitive industries... But this essentially mercantilist reasoning just moves the paradox from a domestic setting to an international setting...

So more work, most likely in the direction of nonlinear mathematical modeling, is necessary to understand how to achieve prosperity and fairness. And today's world is definitely in need of new economic views.

Complex systems and Keynes approach

It is often said that Adam Smith (1723-1790) is the first economist to have proposed a systemic view of Economics. Indeed he clearly saw that a system is at work when economic agents produce, exchange and consume (and save, invest, etc.). He said that "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest". And he introduced the concept of "Invisible hand". These are definitely "complex dynamic systems" ideas.

In fact, Quesnay (1694-1774) already had some systemic understanding of Economics, despite the fact that he said that only farmers produce wealth. Quesnay made the first deliberate attempt at constructing macroeconomic measures of the economy of a country, and at modelling their evolutions (Quesnay zig-zag design). One can even distinguish some systemic thinking in the reasoning of the mercantilists (for instance Colbert (1619-1683)) who advocated launching state manufactures to collect gold and finance the state.

Yet Smith, like all his contemporaries, had a poor intuition about the workings of these systems. He thought that the economic system converges toward stability and that the stable state is optimal. Trying to prove this under various sets of hypotheses has kept economists busy for two centuries. (But the most elaborate models don't use money !)

One of the culprit hypotheses that leads to the mistaken feeling that economic systems ought to converge toward stability and optimality is the hypothesis of decreasing efficiency of agent's resources. Everyone who has worked a bit in the real world of firms and competition knows that this hypothesis is wrong. (The hypothesis seemed natural to XVIIIth century economists because they were still impressed by the ideas of the Physiocrats who said that only land produces wealth, and the law is realistic when working land with the techniques of that century.) Let's take the simple model of a little community with various agents and in particular two bakers. If for some reasons one of the bakers is pushed out of work, his efficiency to start over again producing bread is not higher than the baker who remained in business but much lower. So he will have a tough time reentering the trade. And conversely the marginal efficiency of the remaining baker is very high, not very low. So the remaining baker will easily take over the business of the pushed out baker. What is true is that the pushed out baker can either become an employee of the remaining baker, and for Marxist economists this is an illustration of relationships of strength and exploitation of man by man, or he can do something new. The naive supporters of liberal systems say that it is the obvious solution. But usually they are teachers in universities with tenured positions, and have no experience whatsoever of what it is to start over anew. And of course so long as the pushed out baker hasn't got back a new well paid activity (that is an activity which generates a substancial flow of money in and out of his accounts) it is the whole community that loses, because he can no longer purchase what he used to purchase. All the other agents who supplied him also see their own revenue decrease. These considerations only scratch the surface of complex dynamic systems.

Keynes (1883-1946) is the first economist to have clearly understood that Smith system does not converge to an optimal state. He stressed that the dire unemployement level of the Great depression was not the result of too high wages, and that lowering the wages even more would not solve the crisis. (One of my grand fathers, Amaury Lebon, who was a wealthy architect in the 20's, car, spacious house, etc., lost most of his work in the 30's, and became an employee of the reconstruction agency after the war.) To Keynes the system was endogenously producing the crisis, because of other imbalances. He searched for causes in the management of the money supply. He opposed Pigou's ideas about the "real balance effect" that should also lead back to an optimal stable economic state.

Keynes proposed a bold solution : the State should substitute for the failing industrial sectors in investing and henceforth start over again the economic machine. He explained that there would be a multiplicative effect, etc. (Note that any expenditure has a multiplicative effect, not only those made by the State.)  Pres. Roosevelt applied Keynes ideas in the 30's, for instance in the Tennessee Valley Authority project. Keynes ideas dominated western economies from 1930 until 1980.

Of course the idea of State intervention did not appear with Keynes ; there are many examples from the past. In fact before large market economies emerged after, say, 1600, a part of the activity of society members was organised by State authorities to construct public works, cathedrals, city walls, palaces, etc. But this was mostly achieved not through market economics.

The Mercantilists of the XVth and XVIth century had strong (and biased) views on state responsibility to bring wealth. But Keynes goes one step farther than the Mercantilists, since he proposes to intervene within the domestic economy, and not only set up exporting manufactures to import gold.

It is still debated whether it is the keynesian economics of the 30's or the more brutal war economics of 1939-1945 that helped relaunch the US economy. It has also been pointed out that Keynes policy is a step toward central planification, which has dramatically shown its inadaptation to human nature.

Whatever may be true, it is sure, from the viewpoint of complex systems, that Keynes recommandation does not take into account the subtle effects on the economic machine of changes in public policy. And that will have to be investigated with the new tools that will be constructed in the field of complex dynamic systems.

For instance when one hears on the radio that "the government is planning to finance more agencies to be in charge of helping unemployed people to find back a job" one knows that this ignores entirely the dynamics of complex systems, and without any ideological slant one can predict that it will be a failure.

Between "no government" that leads to suboptimal economic states, and "big government" that leads to economic disruptions what is the way of the future ? Most probably the same as for organisms : the organisation of local communities of various sizes with a large degree of autonomy, with some central "nervous system".

Another issue that Economics has not resolved is this : is it possible to create a satisfactory economic system without a positive selfless contribution from its members ? It's been four centuries that economists grope for proofs that, within a certain legal framework, i.e. rules of the game (which already imply the notion of "a community" and of "an ultimate power" to enforce the rules), it is possible - without success.

References :
1) Political economy, 1740 - 1860  by Stewart Crehan
2) Spontaneous order Wikipedia article (a wonderful example of community construction with a positive selfless contribution from its members).
3) For some thought provoking ideas : Energy economics
4) For a discussion of the Invisible hand from classical mathematics, as opposed to the mathematics of complex dynamic systems

Go to part two