Finance with a review of accounting

Promissory value

The two types of value

There are two types of value

1. real (also called "tangible") value:
   • it is the value created by work: a sack of rice, a house, an airplane seat, etc. It can be perishable (like a salad, or an airplane seat), or durable (like a house)
   • it can also be the value created by a change in the desirability of something: if I own a tract of land the price of which goes up for urbanistic reasons, value is spontaneaously created, but it is still to be classified as real value; and I am the happy beneficiary of this increase in value
     
     
2. promises (which I call here "promissory value"):
   • it is a promise, written on a piece of paper (or equivalent), signed by someone (usually a borrower) to pay some money to the bearer in the future.

Example

Creation

A promissory note is usually created in a transaction between two agents, A and B, when for instance A delivered some real value to B, and B intends to pay (with real money) later. In the mean time B hands to A a promissory note of the type shown above. (In the above example A is the teacher, and B is John Doe.)

This promissory note has a value today. A can sell it to another agent C. In other words it has a price today. Finance will tell us precisely what is the price today (23rd Oct 2008) of this promissory note, but that is not our concern right now. The point is that value has been created "from scratch" and it increased the amount of value in circulation in society.

There exists even a more effortless creation of value! The real life case is when a bank opens a credit to John Doe (on the liability side of the bank balance sheet), and at the same time registers a new loan to John Doe (on the asset side of the bank balance sheet). Here two promissory values have been created! : the new loan on the asset side, and the new money available to John Doe on the liability side.

The new loan on the asset side can be sold by the bank to other economic agents. And banks do this all the time, via securitization or otherwise. Furthermore the new money created on the liability side can be used by John Doe for all sorts of payments.

In theory there are limitations (linked to the amount of "reserves" banks hold) to the amount of money banks can create that way, but the process of securitization has proved to be a means of overcoming these limitations.

Origin

The origin of modern promissory value (i.e. paper value) - we have seen - is the bills of exchange big merchants began to use at medieval trade fairs in Western Europe around the XIIth century.

These promissory notes remained private contracts for several centuries, even though they became "bank notes" in the XVIth and XVIIth centuries, when banks developed independently of trading activities of operators like the Medici or the Fuggers.

Money

Modern money (paper bank notes, and electronic bank accounts) is the direct heir of bills of exchange and bank notes.

Parallel to the construction of nation-states (from feudality to monarchies, then absolute monarchies, and finally parliamentary monarchies or republics in the Western world), these nation-states took over the control of their paper money, and selected one big bank (in the XIXth century most usually) and granted it the monopoly of issuance of legal tender bank notes.

So when we say "B will pay with real money in the future", we must not overlook the fact that real modern money is actually promises too (what is called in school textbooks "fiduciary money").

It was first understood that commerce needed money that did not have to be necessarily gold by John Law in the early XVIIIth century. Here is one of his famous treatises before he became an actor in finance in France: Money and Trade Considered With a Proposal for Supplying the Nation with Money

Present problems

The deregulation of the last 30 years (the so-called Thatcher/Reagan revolution), together with the computer revolution facilitated the issuance of more and more sophisticated promissory value.

The subprime loans are only one example of such sophisticated financial contracts, in this case between US homeowners (borrowers who issued the notes) and US lenders who in turn securitized their loans and sold them to the whole planet. It turns out that roughly $2000 billion of those housing mortgage loans (with complex repayment conditions) are now bad.

And the large quantities of bad loans in the banking system already lead many banks to go bankrupt. In order to avoid a "domino effect", as well as a dangerous tightening of credit, central banks and governments stepped in to inject money into banks, nationalize some of them, and try to prevent a crisis of the "real economy" (i.e. recession, unemployment, people thrown out of their home, poverty, etc.).

Future

At present various international meetings are organized, gathering heads of states and finance ministers, to try and put back more control on world financial activities.

It is in this light that must be interpreted President Sarkozy's recent phrase "Did I become a socialist? Perhaps."

The problem is that it is really a more fundamental fight (of the scale of the fight between the pope and temporal princes in the late middle ages) between nation-states and new supranational financial agents.

The computer revolution has made possible the emergence of supranational agents who wield a power equivalent to many states. They will be able to issue "new private moneys" more reliable than the official currencies. So the future 10 to 20 years, which will see the beginning of the demise of nation-states (in truth, already begun), are going to be rocky.

In France, in particular the slow loss of power by the government (which we already witness), will probably trigger more and more strikes in public services and social unrest.

The last 1000 years have seen emerge in the West a strong centralised order resting on "nations". A nation is a group of people linked by common cultural heritage, language and history. Yet the nations forming Europe at present were born in violence. In France in the XIXth century all the regional specificities were severely fought by the central authority, in particular in schools. At the monetary level, all Local Exchange Trading System (LETS) are strongly controled and prevented to grow. Most of the world, at the beginning of the XXIst century, is divided into countries which do not correspond to natural nations. We are probably at the outset of profound reorganizations of world communities, possibly no longer based on geography.