1. The Hierarchy of Money

“… the German construction group has sold assets, reduced debt and switched its focus away from winning orders and towards cash flow” (Financial Times, 2016).

 

There is a hierarchy of money, which was established due to many historical events and circumstances. Gold is on top of the hierarchy because you can not “make” more gold. This makes it a scarce commodity. Furthermore, back in the days, every merchant or country accepted gold as a means of payment.

What would you rather get paid in hundred of years ago? In real gold or a currency that is only worth something, because a government puts a stamp on the note, but that could be a worthless piece of paper depending on the government and whether it’s forged? What happens if there is an inflation or if you can’t pay with the foreign    currency in your home country?

Which leads us to the next step in the hierarchy: Currency

Especially today, currency is widely accepted and backed up by the government. The government puts a stamp on a note and promises that it is worth that amount and we have to trust in this system.

So currency is almost as good as gold and it is definitely easier to have a hundred dollar note in your pocket than a gold bar.

Back in the days where the currency was backed up by gold, the currency was almost as good as gold. Nowadays it is backed up by the government, so it is actually a liability of the government. They put a stamp on a note and promise that it will be worth a certain amount e.g. $20 and they promise to always pay you that amount. Unfortunately, nowadays instead of giving you gold for your notes, you would get another 20$ bill, but because the government has to give you this $20 it is a liability of the Central bank. I will talk more about liabilities and assets later, so bear with me.

 

Gold and currency have to obey the law of scarcity

What does that mean? You can not make more gold, so there are boundaries to the amount of gold in this world. You also can’t print money or at least you shouldn’t, so there is also a scarcity there.

But credit and deposit are not that scarce, you can actually create credit:

If I you buy me a drink for 10$ and you say I should pay you back tomorrow, you have created a credit. I have to give you a 10 $ note tomorrow, but imagine I only have a 5$ note. I can’t just stretch this bill to make it worth more, but what I could do, is to overdraw my deposit account at the bank and transfer the money to your bank account.

That leads us to deposits. They are worth less, because they are based on credit. Even if I don't have enough money on my deposit account, I can still pay you. The bank gives me a loan and I transfer the money to your bank account. 

What happens if the bank or I suddenly can’t pay you? Then you wish you had a 10$ note in your hand. That is why currency is better than a credit or an I owe you (IOU).

 

The last thing in the hierachy are securities

What is an example for a safe security: A bond from a very good company with a lot of cash like Apple or even better from the government. You bought it for 100$ and they pay you back 110$ in 10 years. Now the economy and  the company could go down and you suddenly need money after 5 years, so you want to sell your security. Unfortunately, the economic situation is pretty bad right now, so only one person offers you to buy that security for 50$, so you lose 60 $.

You really need money though,so you have to sell it for 50$.

The hierarchy of money is linked to liquidity (how easy is it to sell it)  and scarcity (how big is the quantitative amount). The more liquid and scarce an asset, the higher it is in the hierarchy.

It's crucial to understand balance sheets

My professor said: "The world is a world of interlocking balance sheets." My asset is someone else’s liability. What does that mean? A company bond would be an asset for me and a liability for the company, so you can see it on both balance sheets. Assets for a company or private person are things they are owning like houses, money, stocks, bonds, inventory and liabilities are things I have to pay: bills, loans or mortgages.

So if I lend money to a company, I gained an asset. Whereas the company borrowed money, which they have to pay back to me, so they gained a liability. 

 For banks it is the opposite. Their assets are things they make money with. Mainly they make money by lending money. Thus giving away loans are an asset. On the liability side are promises to pay for example deposits, or if the bank borrowed money from another bank.


Left side: Balance sheet of a construction company; Right Side: Balance Sheet of a bank

What is meant by saying: We have a dynamic system that can expand?

How is it possible that there is more and less “money” in this world.  As we go back to the pyramid this pyramid can get wider or more narrow. In times of economic boom banks are giving away credit and everything is expanding, whereas if we are in a recession banks are too scared to lend money to companies and private households. Furthermore, companies can’t afford to take out loans so they just pay back their credits and the pyramid is getting smaller. This concept becomes much more clear in the chapter: How banks create money out of thin air but keep this in mind.

 

Financial Times  Quote: Think in balance sheets: The construction company sells it's security to get currency, which is higher in the hierarchy of money. They sell assets and gain money, whereas the investor on the other side "loses" money and gains new assets.

I hope you enjoyed the first part of the money and banking series. Do not give up too early, it takes a while until you get into it and develop a deeper understanding.

Introduction

 

The second article: Why do we need banks?

The third article: Why we need a central bank?

The fourth article: How can banks create money out of thin air?

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

The seventh article: What are Fed Funds?

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

The eleventh article: Discounts, Discounts, Discounts

The twelfth article:  Why dealers provide liquidity

The thirteenth article: Rates and the Treynor Model

The fourteenth article: Brexit

 

Written by: Philine Paschen

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