1)
In a
transaction taking place in 2004 you sell something to someone, and you are
proposed, in payment, to receive either 100 euros today, or a promise to
receive for sure 105 euros in one year. What do you prefer, and why ?
A transaction is always an exchange of two things, AT
THE SAME TIME. This is true in Finance, as well as in Accounting.
Accounting is difficult to understand so long as we
overlook this fact. If we use the standard way of thinking :
“I sell something, therefore there is one account involved, here it must be the
Sales account…” we are mislead. We must look at the two movements
: something leaves us, or our firm (it’s a sale), and something enters
our firm (the payment : cash, cheque, IOU, promise of one sort or another). But
it takes place now.
In business, and economics, we study EXCHANGES. Even
production is done through exchanges : purchase of
labour, and of raw materials, to produce products, and then the sale of them.
We live in societies based on exchange. The power of
exchange has proved very strong to create wealth and to consume it. Between the
beginning of this lecture and its end, in three hours, the population of the
world will have increased by 30 000 people. Our lives are pervaded with
values related to exchange : consumption, ads, prices,
supermarkets, efficient production, etc.
The whole purpose of Economics is to study the conditions to create prosperity (production and fair distribution) in societies. In Economics courses, in schools, we learn conventional economical knowledge, that studies exchanges governed by “the law of supply and demand”. But everybody knows from experience that it does not apply well to reality. That’s one of the reasons why Economics is called “the dismal science”. For instance Adam Smith said that, in a group exchanging, an invisible hand (that is, a system) leads, via the selfish behaviour of each one, to the well-being of everyone… The reasoning goes as this : “If there is a lack, and therefore a demand, for a product, the prices will go up, suppliers will appear, attracted by the profit, they will make money, and then the suppliers and the rest of the community will be satisfied…” Everybody knows it doesn’t work like this in real life.
Put 100 people together in a community and let them exchange. Relations of strength will appear parallel to exchanges. These are related to personal values next to "common values". When we exchange a product A for a product B, it is because we have a personal value for A higher than for B (and normally it is the other way around for the other person). These personal values can lead to relations where we are in a weak position and are forced to accept the exchange. Relations of strength pop up at first from chaotic phenomena. And then they shape the structure of the community.
Economics studies complex systems created by exchanges
in a community. It leads to complex dynamic structures. To some extent
exchanges lead to more production. But it does not lead to fair distribution.
This has nothing to do with good and evil. It is social dynamic. Exchange
mechanisms lead to the emergence of complex structures. That is exactly how
life appeared 3 billion years ago : special types of
molecules formed proto-cells simply because they were partially hydrophobic
(like soap). Then, much later on, when they had become eukaryotic, they began
to form multicellular bodies, and these bodies began to specialise and to
exchange, within each other and between each other. Exchange is the engine of
life, but it doesn’t lead to uniform prosperity, it leads to complex
structures.
Everything we study in this
program, for three
years, has to do with the study of exchange to create wealth, prosperity and
fair distribution. Commerce means exchange. In fact these topics are very hot
topics nowadays in the international community. Questions like
:
·
Should the
·
Should the international community
help
·
Should
·
Should the World Bank impose market
economies to countries asking for its help ?
Firms are social entities to create wealth. It is done
via exchange. Then this wealth is distributed via the mechanisms of money, and
prices.
The well-being of our societies rests in part on these
mechanisms.
Accounting is just a set of simple techniques to
record exchanges (products and values). It is not concerned with the time value
of money. Not so in Finance.
When I give away something with the promise to be paid
later, I receive TODAY this promise, usually it has
some material support (a piece of paper, some legal proof…)
We prefer, in payment, what has the more value.
What has the more value ?
100€ today or a promise for 105€ FOR SURE in one year ?
Ans. : 105€ for sure in one
year ! Why ? Today in
If I have a promise for 105€, for sure, in one year, in my pocket today, I can sell this to someone else for 103€ ! It is definitely better than 100€.
Notes :
that price today of 100€ to acquire the future CF of 105€ becomes a normal price to us or even too high a price if the future cash flow is a random variable (at least that's how financiers reason)
why the hell would anyone give us, in exchange for 100€ given to him or her today, a promise worth to us more than 100€ ? Ans. : that is where personal values and prices, and relations of strength enter the picture.
It is when we overlook that we compare two things AT
THE SAME DATE that we begin to be confused. We give today a product, and we
receive TODAY either 100€ or something else (namely a piece of paper that is a
promise, to receive 105€ in one year).
This also applies to accounting :
accounting becomes very confusing when we overlook the fact that a transaction
(the elementary operation of a firm, that is, an elementary operation in the
process of creating wealth and of exchanging wealth) is TWO MOVEMENTS (one in
and one out) AT THE SAME TIME.
One difference between accounting and finance is that
accounting is not concerned with the monetary difference of value between 100€
of cash today, and a good client paper promising to pay 100€ in two months. We
use the historic cost rule for our recordings. We know its drawbacks, but it is
very robust, and has proved useful.
Accounting makes casual use of money. Finance makes a more sophisticated use of money (cash). Money is a more complex and elusive concept than appears at first glance : money is value that can be exchanged readily with no effort to convince the other party ; either it has "value on its own" (like gold used to have) or it bears a signature and therefore it is worth as much as the trustworthiness of the signatory ; banknotes bear the signature of a State's monetary authorities, and are legal tender within that State, but that does not give them automatically "absolute value" (the Rubble used to be worth one dollar, now it is worth 3 cents) ; modern developed countries governments tend to be irresponsible with the management of money (they issue it, or promises, to finance deficits to maintain their electoral base ; that's the drawback of modern democracy : clientelism ; in fact "clientelism" is everywhere : it is the use of own's power to obtain as much as possible ; when a purchaser chooses a supplier there are few effective barriers to prevent the supplier from paying nice holidays to the purchaser in order to be chosen ; the same applies to governments ; the same applies to academic elections : academicians select new entrants that will advantage them, serve their interests, be their "obligés" ; that's social dynamics and relations of strength to maximise one's well being).
Economics is still fraught with concepts of good and
bad. This is a characteristic of immature sciences, to be full of values and
concepts dating from the time when priests and philosophers were the people in
charge of describing the world. They did it, but did not always took the pain to look at it first. They mixed up “common
sense”, personal convictions, and social purposes. Aristotle claimed it is
obvious that heavier bodies fall faster… Their motivations were of another
nature than sheer knowledge. There are ideas, nowadays commonly accepted, that
were mindblowing and unbelievable to man 500 years ago : for instance, the
world is not flat but a sphere floating in space, and people and waters
underneath us do not fall… If we think of it, it is unbelievable we even accept
this. Another example of idea quite ununderstandable today is this : the concept of time, as we know it, does not apply to
very long periods in the universe, and to talk about what happened earlier than
20 billion years ago is meaningless.
The same will happen in Economics, and in Finance, particularly
concerning Money.