Lecture One
Econ 350
Money and Finance, 2010
Introduction
Associate Professor Sean Turnell
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The financial system [is] the brain of the
economy…It acts as a coordinating
mechanism that allocates capital, the
lifeblood of economic activity, to its most
productive uses by businesses and
households. If capital goes to the wrong
uses or does not flow at all, the economy
will operate inefficiently, and ultimately
economic growth will be low.
Frederic Mishkin (2006)
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Money, money, money, always funny, in a
rich man’s world…
Benny Andersson and
Björn Ulvaeus
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„ …the ascent of money has been one of
the driving forces behind human
progress: a complex process of
innovation, intermediation and integration
that has been as vital as the advance of
science or the spread of law in mankind’s
escape from the drudgery of subsistence
agriculture and the misery of the
Malthusian trap.
Niall Ferguson (2008:342)
…the formal financial system is profoundly
important for the poor. It influences how
many people are hungry, homeless and in
pain. It shapes the gap between the rich
and the poor. It arbitrates who can start a
business and who cannot, who can pay
for education and who cannot, who can
attempt to realise one’s dreams and who
cannot. Finance affects the degree to
which economic opportunities are defined
by talent and initiative or by parental
wealth and social connections.
Ross Levine, 2008
But, as recent events have shown only too
well, the ascent of finance noted by Ferguson
above, has not been a smooth one.
Punctuated byy manias and p panics,, bubbles,,
crashes and human irrationality. And yet…the
long path is clear and apparent.
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 Why Study Money and Finance?
„ Contents:
„ Financial Systems are Special
1. Why Study Money and Finance 1) They constitute the heart (as well as the brain) of the
2. What is Money? market economy – pumping money (credit) from those who
have it but don’t need it, to those who need it but don’t
3. Overview of the Financial Sector have it.
4. Direct and Indirect Financing 2) Finance is a projection into the (unknowable) future.
Because of this, it is uniquely vulnerable amongst markets
5. Financial Markets to all the human frailties – fear, greed, vanity, ignorance,
6. Patterns: Institutions vs. Markets fraud…
7. Securitisation 3) Finance channels resources that are greatly susceptible to
government interference and patronage.
8. Some of the ‘Players’

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4) Because of its ‘specialness’, financial systems are subject to

equally special regulations. Amongst these are
arrangements that implicitly (and increasingly, explicitly)
involve government guarantees. This raises singular
concerns of ‘moral hazard’ and other behaviour distortions i) Some First Steps…
not present in other markets.

5) It has proved almost impossible throughout history to ….What is Money…

constrain finance within the controls applied by
government. t Risk,
Ri k th
therefore,
f has
h never b been abolished
b li h d …What
Wh t is
i Finance…
Fi
– and sometimes it’s enhanced by government intervention.
…Are they the Same?
6) Financial systems are the arenas through which government
implements a critical arm of policy (monetary policy). It
constitutes a medium, as well as a marketplace.

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„ Money is: „ It is, of course, all of the above. But what is it that is
‰ Precious metal? possessed by these things that give them the quality
‰ Precious stones? of money?
‰ Cowrie Shells? „ The important point to note about most of them, is
that they have value because of the social
‰ Copper coins? arrangements each implies. And in this, money:
‰ Paper banknotes? …unites
unites society more effectively than tyranny
‰ Clay tables of owed and owing? or blood; for, in taking money, you deliver
yourself up to the other users of money, accept
‰ Entries in a balance sheet? their freedom to choose, their frivolity and
‰ Plastic cards? selfishness, their universal subjection to desire,
‰ Bits and bytes? their humanity’.
Buchan 1997:20

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„ ‘Moneyness’ is not an intrinsic attribute, and does
not have a particular form – but represents the
ability to acquire. According to Buchan (1997:19)
money is incarnate desire:
…money has always and will always symbolise
different things to different people…to one person a
drink in a pub, a fairground ride, to a third a diamond
ring, an act of charity to a fourth, relief from
prosecution to a fifth and, to a sixth, simply the
sensations of comfort or security.
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ii) There is much hostility to finance and financiers
today
„ But there always has been.
„ In most cultures and religions, the financier has
been seen as a parasite at best, and vermin
metaphors (and worse) have never been far away.
„ The established monetary order is also usually the
target of romantic fiction (eg, Jane Austen – even as
her novels seem obsessed with accounting for
annual incomes…), which can only be blown away
by ‘other passions’. And, of course, it is still
considered vaguely ‘not quite right’ to give money as
a present.
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„ And here’s Keynes (1931):
The love of money as a possession – as
distinguished from the love of money as a
means to the enjoyments and realities of life
– will be recognised for what it is
is, a
somewhat disgusting morbidity, one of those
semi-criminal, semi-pathological propensities
which one hands over with a shudder to the
specialists in mental disease.
17
„ Schopenhauer made an almost identical point
(1968:414):
Men are often criticised in that money is the chief
object of their wishes and is preferred above all else,
but it is natural, even unavoidable. For money is an
inexhaustible Proteus, ever ready to change itself
into the present object of our changeable wishes
and manifold needs. Other goods can satisfy only
one wish and one need. Food is good only for the
hungry…medicine for the sick, fur for the
winter…Money alone is the absolute good: for it
confronts not just one concrete need, but Need in
itself in abstract.
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„ Aristotle (c.330, Politics) – on that profit and
‘interest’:
…is justly censored; for it is unnatural, and a mode
by which men gain from one another. The most
hated sort, and with the greatest reason, is interest,
for it makes a gain out of money itself, and not that
for which money was devised. For money came into
being for the sake of exchange, but interest makes
the money itself greater…Interest, which means the
birth of money from money, is applied to the
breeding of money because the offspring resembles
the parent. That’s why it’s the most unnatural way of
enriching yourself.
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„ Yet, here’s the same man in 1936 (in the
General Theory):
It is better that a man should tyrannise over
his bank balance than over his fellow citizens.
„ Why the hostility?
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Three reasons according to Ferguson (2008:2-
3):
1) Debtors outnumber creditors
2) Crises and downturns have often appeared
to have a financial cause
3) Finance…in many places…has been
disproportionately provided by ethnic and/or
religious minorities.
Buchan (1997:32) suggests (apropos of
Aristotle, a sexual taboo is at the heart).
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„ Finance is BIG and, up until 2008, growing. In
2006:
‰ Global GDP = $46 trillion
‰ Global Stock Mkt Cap = $51 trillion
‰ Global Bond Mkt = $68 trillion
‰ Global Derivatives = $473 trillion
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„ Some big lessons from the history of money
and finance:
‰ Poverty is not the result of the behaviour of
rapacious financiers, but the absence of finance
and financial institutions.
‰ Finance exacerbates and exaggerates existing
disparities.
‰ Financial crises are difficult to predict.
Ferguson 2008
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„ People should always be careful in what they
wish for. Moneyless utopias have been
imagined throughout history. The first was
perhaps Plato’s Republic. Some are
harmless (Sir Thomas More) others, perhaps,
end in mass murder. The latest, the Khmer
Rouge’s
Rouge s ‘Year
Year Zero
Zero’ will undoubtedly not be
the last.
„ Such hostility, however popular and endemic,
is wrong-headed and, as we shall see, most
episodes of human achievement have a
supporting financial foundation.
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„ In 1947, the US financial system accounted
for 2.3% of that country’s GDP
„ In 2005 it contributed 7.7%
„ In the UK its contribution was 9.4%
„ Ferguson 2008:4-5
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Overview of the Financial Sector
„ The role of the financial sector:
‰ Facilitates trade by creating an efficient and
secure payments system.
‰ Allows the aggregation
gg g and flow of funds from
saving to investment through both financial
markets and institutions.
‰ Creates products for the management of risk –
futures, options, insurance contracts, etc
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„ Surplus and Deficit ‘Units’.
‰ Surplus economic units (aka savers, lenders,
investors, buyers of financial assets, suppliers of
loanable funds, etc) have more income than they
spend The financial system allocates their
spend.
surplus too…
‰ Deficit economic units (aka borrowers, users of
loanable funds, sellers of financial assets, etc)
have less income than their desired expenditure.
Such units must access the financial system to
match their cash inflow and outflows.
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„ Note, however, that the financial system does
not just match up deficit and surplus units – it
provides them with liquidity via the trading of
financial claims in secondaryy markets.
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„ Of course, brokers (such as investment
banks and other dealers) usually facilitate the
process of creating these claims, and in
bringing the deficit and surplus units together
in the market place
place.
„ In practice, direct financing takes place in the
bond market, equity markets, money
markets, and so on. Such markets, and the
products they trade, are central to this
course.
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„ Financial Claims – the basic descriptor of
financial assets and liabilities. We know them
as loans, securities, investments – assets
and liabilities – but in the end they are
contractual claims of one party (surplus units)
over another (deficit units).
„ Given this, it follows that for every financial
asset their must be a matching liability, and
total receivables in the financial system must
match total payables.
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Direct and Indirect Financing
„ The transfer of funds from surplus to deficit
units can take place directly or indirectly.
„ By direct financing, we mean the situation in
which deficit and surplus units deal with each
other directly rather than through an
intermediary, mostly through financial
markets. Deficit units issue financial claims
(securities – bonds, bills, notes, shares),
while surplus units supply funds by buying
these claims.
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„ Indirect Financing. A financial intermediary (simply,
a bank) stands between (ie, ‘intermediates’) surplus
and deficit units. In other words, the intermediary
creates separate contracts for a transaction
between surplus (eg, a deposit) and deficit (eg, a
loan) units.
„ It is the intermediaryy that holds the direct financial
claim (a loan – an asset) over the deficit unit,
against which it issues a liability (deposit).
„ Why financial intermediation? Abstract economic
theory (Arrow-Debreu) would suggest it’s not
necessary:
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 ‰ Financial intermediaries (FIs) may have
efficiencies in monitoring.
‰ FIs may have efficiencies in transaction and
search costs.
‰ FIs may be able to gather information more
effectively.
‰ FIs allow
allo for denominational transformation
transformation.
‰ FIs allow for maturity transformation.
‰ FIs allow for quality transformation.
‰ FIs allow for currency transformation (where rel.)
‰ FIs allow the pooling and spreading of risk.
‰ FIs provide a place to store or access liquidity
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„ The detailed operations of all of these
INSTITUTIONS is not the focus of Econ 350
(it is, however, the focus of Econ 335 in
Semester 2!!).)
„ Rather, as we shall see in coming weeks, our
focus in this course is on financial MARKETS
and their products. It is to briefly introduce
these, that we now turn.
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„ Primary markets are critical in terms of the
transformation of savings into investment.
„ Secondary markets are critical in providing
liquidity, portfolio balancing, risk trading, and
so on.
„ Financial markets are also differentiated in
how and where trading takes place place.
‰ Organised exchanges (such as the NYSE, ASX,
SFE, etc) provide a central (sometimes physical)
trading place.
‰ Securities can also trade ‘over the counter’ (OTC).
OTC markets have no central trading place.
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„ In Australia, the most relevant financial
intermediaries in the context here are the so-
called ‘Authorised Deposit-Taking Institutions’
(ADIs). These enjoy unique status and
regulation under the Australian Prudential
Regulation Authority (APRA). Such ADIs
include; banks, building societies, credit
unions. Performing similar intermediation
functions, but non-ADIs, are superannuation
funds, life offices, insurance companies,
public unit trusts, mutual funds, etc.
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Financial Markets
„ Financial markets are the areas through
which direct financing takes place.
„ Such markets may be differentiated
according to when a security (a financial
claim) is sold and bought.
„ The initial financing of deficit units takes
place in primary markets. The subsequent
trade in their securities takes place in
secondary markets.
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„ Another way in which financial markets are
differentiated is according to the maturity of
the securities they trade.
‰ Short-term (<1 year, but often much shorter)
securities are issued and traded in what we call
the money market.
‰ Longer-term (>1 year) securities are issued and
traded in the capital (equity) and bond markets.
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„ The time element also enters into the picture
in differentiating between spot and futures
markets. Here the timing issue concerns
delivery and payment.
‰ Securities traded in the spot market are for
immediate delivery and payment.
‰ In futures or forward markets, such delivery and
payments are not immediate (indeed, the
alternative is their purpose)
‰ The difference between futures and forwards
contracts? – Futures contracts are traded in
organised exchanges, forwards ‘OTC’.
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„ Foreign exchange markets deal in national
currencies.
„ In foreign exchange markets trading takes
place in all variety of ways – spot,
spot forward,
forward
futures, options, etc.
„ Foreign exchange markets are not, however,
the focus of Econ 350 (rather, they are
covered in Econ 360).
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„ In the Australian context, the growth of
superannuation played a role too – on the
‘demand side’.
„ Likewise it was driven here (and elsewhere)
Likewise,
by the trend to ‘securitisation’.
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„ Options markets are yet another variation on
the theme – trading in securities that specify
conditional or contingent prices and delivery.
‰ A ‘call’ option
p is an option
p ((but not an obligation)
g )
to buy a security; a ‘put’ option is an option to sell.
‰ Options are traded both on organised exchanges,
and OTC.
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Patterns in Institutions vs. Markets
„ Up until the 2008 global financial crisis
(GFC), financial markets were increasing in
importance in Australia (and around the
world)) at the expense
p of financial
intermediation.
„ This was true both in terms of primary
markets and secondary markets.
„ To some extent the rest of the world was
playing ‘catch up’ to the US and the UK.
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Securitisation
„ By which we mean the financial packaging or
‘bundling’ of an income stream derived from a
financial asset (of just about any type). These
are then sold as asset-backed securities.
„ Examples of securitisation are legion – but
amongst the most prominent examples
include the securitisation of home mortgages,
credit card receivables, student loans, car
loans and so on.
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„ In Australia, the rapid growth of home-
mortgage securitisation is particularly stark –
from 5% of the total mortgage market in
1996,, to around 25% byy 2007 (problems
(p
emerged soon after…). Of course, behind the
growth were some well-known brand ‘faces’ –
Aussie Home Loans, Wizard Home Loans,
Rams…etc. And behind these, were the likes
of Macquarie and other ‘investment’ banks.
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1. Fashion;
2. High demand for home loans
3. Cultural disposition for home-ownership
4. Rapid growth of mortgage originators
5. Increasing reliance on securitisation as
funding vehicle for regional banks, building
societies and the like
6. Growing familiarity internationally with
Australian mortgage market – and
recognition of its peculiar qualities.
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„ The issue of securitisation, and much else
besides, is now greatly clouded by the Global
Financial Crisis (GFC), even as longer-term
trends and issues (such as ageing
populations) will continue to yield their
impact.
„ Until the GFC we often noted the importance
of liquidity, breadth and resilience for well-
functioning markets – and assumed such
virtues were becoming entrenched.
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„ By 2004, Australia’s mortgage-backed bond
market was the third largest in the world
(behind the USA and the UK). This in turn
had made the overall asset-backed bond
market the fifth-largest in the world.
„ Why the specific success of mortgage
securitisation in Aus?
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„ Why the growth of securitisation, generally
and internationally:
1. Fad and fashion
2. Fees
3. Perception of improved credit and liquidity risk
management for FIs – placement of risk with those
with an appetite for it – insurers,
insurers speculators,
speculators
hedge funds…
4. Funding diversification for FIs
5. Improved balance sheet management for FIs
6. Improved capital management for FIs
7. Expanded market – low doc and sub-prime
anyone?
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Some of the ‘players’ in financial markets
„ Dealers/Market Makers: Trade securities on their
own account, according to bid/offers they have
placed in the market. Profit on the spread between
these prices, which fluctuate according to the
movement of the market itself. Sometimes such
players enjoy a special franchise in certain assets in
return for a commitment to be market makers (eg,
RBA authorised forex/CGS dealers).
„ Brokers: Rather than hold their own inventory, tend
to act simply as agents for clients wanting to buy or
sell securities.
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„ Speculators: Take positions in the market in
the hope that prices move their way. We shall
examine later the question of whether
speculation is stabilising or not (or whether it „ Finally – the ‘moms and pops’, the hoi polloi,
is either). Note the importance of short-selling the ‘noise traders’…the taxpayers
in the toolbox of speculators – one doesn’t who…prove very useful in a crisis!
need to ppunt jjust on rising
gpprices.
„ Arbitrageurs: Seek to exploit prices
differences on the same asset/asset
categories in different markets. Later we shall
see how this label is sometimes employed in
the context of traders with good information.

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