EC120 Week 10 Notes: Innovations and Crises in Finance

Finance: What it is, What it does, How it Changes

  • Finance involves payments, resource transfer across time/space, and pooling resources.
  • Financial systems are fragile due to reliance on trust and confidence.
  • They evolve over time, with institutions and instruments changing but performing similar functions.
  • Effectiveness varies with economic and political systems.

Financial Instruments and Money

  • Money, long-term securities (debt/stocks), and short-term securities are key instruments.
  • Borrowing and lending are fundamental, often secured by collateral like land via mortgages.
  • Interest is paid by borrowers, sometimes controlled by usury laws.
  • Debt can become marketable, especially bonds for long-term and bills for short-term transactions.
  • Stocks are equity, representing ownership and dividends.

Key Features of Money

  • Money functions as a unit of account, medium of exchange, and store of value.
  • Confidence is crucial for money to function properly.
  • Forms of money vary (shells, coins, notes, deposits), but functions remain the same.

Money: How Much Has Changed?

  • Historically linked to precious metals as coins.
  • Governments intervene, often minting coins and sometimes debasing currency.
  • Multiple currencies often circulate.
  • Forms evolve: coins to bank deposits to electronic transfers.

Multiple Monies

  • If all states use the same metal (e.g., gold), exchange rates can be fixed, forming the basis of the Gold Standard.
  • Bimetallism involves governments minting gold and silver, fixing their relative mint value.
  • Token currencies (less-precious metals) were introduced to address the problem of small change.
  • Money substitutes, like bank notes and deposits, are created by banks.

The Role of Banks

  • Banks link money and credit through borrowing and lending.
  • They borrow short-term (deposits) and lend long-term (loans).
  • Borrowing creates liabilities; lending creates assets.
  • Banks perform asset transformation, with liabilities being short-term and assets longer-term.
  • Bank runs occur in crises of confidence, making banks inherently fragile.

Financing Trade

  • Credit is vital for trade expansion due to transit times and production processes.
  • Specialized institutions lend to buyers/sellers, obtaining funds and lending at interest.
  • Bills of Exchange facilitate trade credit; banks discount them.

Bills of Exchange

  • Bills of Exchange are instruments for short-term credit, contracts between buyer/seller for future cash settlement.
  • They are often guaranteed by an acceptor (bank).
  • Bills can be traded for cash before settlement.

Operation of Bills of Exchange

  • The drawer originates the bill, promising payment.
  • The drawee (typically a bank) accepts it, guaranteeing payment.
  • The bill can be sold or handed to the payee.
  • Discounting involves selling the bill for less than its face value.
  • The bill can be discounted multiple times before maturity.
  • As a negotiable instrument, the holder has recourse to the drawer and endorsers if the drawee defaults.

Long-Term Finance

  • Long-term debt supports land markets via mortgages.
  • Bond markets for government debt emerged in the 18th century.
  • Corporate bonds financed infrastructure.
  • Stocks and shares represent equity.
  • Long-term financial markets are vulnerable to crises, such as government default or loss of confidence in joint-stock companies.

Joint Stock Companies

  • Joint Stock companies divide equity among stockholders, amassing capital and sharing risks.
  • Incorporation provides a separate legal identity and transferable shares.
  • Methods of incorporation include royal charters and Acts of Parliament.
  • Stockholders have unlimited liability unless limited status is granted.

Financial Crises

  • Crises in long-term capital markets depend on investor confidence.
  • They often involve government debt and shares of Joint Stock companies (e.g., South Sea Bubble).
  • The Bubble Act of 1720 required royal charters for incorporation.
  • Banks can play a role in credit crises, especially in fragmented systems.

The South Sea Bubble

  • The South Sea Bubble was a classic financial bubble, with rapid price increases followed by collapse.
  • Expectations of future price rises became a self-fulfilling prophecy.
  • Loss of confidence led to a collapse in share prices.
  • The bursting of the bubble had limited economic impact beyond London.

Economic Fluctuations

  • Pervasive, irregular fluctuations and crises occurred, with regular trade cycles appearing later.
  • Harvests significantly influenced economic fluctuations.
  • Credit crises were associated with fluctuations in trade.

Finance and Capital: Banking System

  • Gold parity was restored in 1819/20.
  • Restrictions were placed on private issues of bank notes.
  • There was a trend toward bank amalgamation and branch banking in the UK.
  • The Bank Charter Act of 1844 confirmed the Bank of England's role.
  • Central banks emerged as lenders of last resort.

Expansion of Long-Term Capital Markets

  • The Bubble Act was repealed in 1825, leading to less restricted incorporation.
  • Railways required large-scale investment.
  • Limited liability became widespread from 1856.
  • Recurrent speculative investment manias occurred.

Joining It All Up

  • Governments need revenue, obtained partly from borrowing.
  • Trade requires credit and payment mechanisms.
  • Modern industry needs long-term capital.

What Drives Financial Performance?

  • Fragility or stability of banks.
  • State capacity for government borrowing/taxation.
  • Democratic accountability influences government actions.
  • International cooperation (or lack thereof) affects financial systems.