Advanced finance Lesson 2 Currencies Banking systems Unregulated and offshore banking Financial markets Evolution of financial markets since 1980 Main actors Foreign exchange markets Speculation on the pound in 1992 Asian crisis of 1997-1998 Documents: Spanish economy Japanese economy Go to lesson:

Cross-table of exchange rates, March 10, 2008

Currencies

The world is divided into currency zones, corresponding to developed countries and their areas of influence. There is the dollar zone, the yen zone of Japan, the Yuan zone of China, the sterling pound zone of Great Britain. Since 2002, after a long gestation, several European countries created a new currency, the euro, and formed the eurozone. And there are other less important currencies.

From the Bretton Woods agreements of 1944 until 1971, the dollar was the world dominant currency within an organized world monetary system resting on fixed exchange rates between the dollar and other currencies, and ultimately on the convertibility of the dollar into gold guaranteed by the US at the rate of 1 oz of gold = $35. In August 1971, because of the large volume of dollars abroad that could come back at any time to the US and ask to be converted into gold, and the relatively low gold reserve of the US, President Nixon decided to "close the gold window", that is to abandon convertibility.

After 1971, developed countries tried to maintain an organized system of currencies and exchange rates (Smithsonian agreement 1971, Jamaica 1976, Plaza 1984, Louvre 1987).

The dollar remained the world dominant currency, used in international trade (oil, raw materials, manufactured goods, travels, etc.), but currencies essentially "floated" among each other (example: French Franc versus Dollar). In the 1970's, gold knew a fantastic price increase (to $850 in January 1980), followed by a 20 years decrease, and then, since the beginning of the years 2000's it is increasing again.

Today's situation is still unstable. Some important countries, like China, control the exchange rate between their currency and the dollar (we shall see later how this is done). Some others, like the eurozone, let their exchange rate evolve according to market forces (example: Euro versus Dollar).

It is important to understand currencies. They are the official money of each world country or zone. We shall see in the next section how official moneys are created and managed.

When we sell some manufactured goods from our country to another, how to get paid? In which currency? Eventually we may want to be paid in our currency (for instance to pay the salaries of our employees), but not always.

We shall study below foreign exchange markets, what they are, what purpose their serve, how they function.

Banking systems

In all countries where a developed monetary system exists, there is a banking system with two levels:

1. at the top level there is the central bank, which oversees the whole system
2. at the bottom level there are all the other banks, also called commercial banks (either retail or investment banks)

Retail banks are those which handle the bank accounts of individuals and firms. Investment banks are specialized into financing large projects of firms, carrying out big bond issues, managing operations of merging and acquisition, etc. (Sometimes the term "commercial" is restricted to retail banks, but in this lesson we shall use it for both, since they are now mixed.)

During the great depression of the 1930's, the number of banks in the United States, due to failures, decreased by half, going from around 30 000 to 15 000. It was believe that the crisis had been aggravated by the mix of the two activities in the same banks. So in 1933, the United States passed a law called the Glass-Steagall Act which stipulated that henceforth the two activities should be carried out in different banks, presumably insulating retail banks, providing services to the population at large, from investment banks supposed to be serving only big investors and taking more risks. However, the act was eventually repealed by President Clinton in 1999. In 2008, in the wake of the "subprime crisis", and more generally of the inconsiderate risks taken by commercial banks, the question of going back to an equivalent of the Glass-Steagall Act is considered again.

The role of the central bank is to issue bank notes, to manage the money supply, and to oversee and manage the whole monetary system. We shall understand better this role when we study the balance sheets of a commercial bank and of the central bank.

Above is shown the balance sheet of a commercial bank. On the liability side there is the usual capital plus retained profits, some possible borrowings from other banks or bondholders, and the depositors. We saw that these depositors made deposits that are akin to loans of money to the bank, but can also be created in exchange for the creation of a new loan on the asset side. All sight deposit accounts at commercial banks are called "electronic money". It is important that you understand very well the mechanisms of these various accounts.

On the asset side, we have, from bottom to top (i.e. from most liquid to least liquid), a little bit of cash in the form of coins and bank notes (like euro bank notes), then every commercial bank has an account at the central bank (which is in credit at the central bank, just like your own account is usually in credit at your bank), then some very liquid financial assets (like Treasury bonds), then various loans to firms, municipalities, government agencies, and private individuals. There are also (we haven't represented them) some physical assets like buildings and equipment.

As we see, the cash + holdings-at-the-central-bank (C.B. reserves) are usually smaller than the depositors potential claims on the bank. This is at the heart of banking: since it is unlikely that all depositors come to the bank at the same time to get "their money back" (which is called a run on the bank), the bank can lend some of its deposited money, while still ensuring that if you want your money back you can get it from your bank.

Runs still exist in our times. In September 2007, there was a run on Northern Rock. And, in early 2008, Great Britain is refinancing and nationalizing Northern Rock, to the great dismay, in England, of tenants of strict liberal ("Thatcherian") economics.

The question of what is the proper level of liquid reserves that commercial banks should maintain, with respect to their deposits, has been a debate for at least two centuries. In the XVIIIth century, before the invention of "legal tender bank notes", you will remember, banks kept 100% gold reserves corresponding to their deposits.

Following the temporary suspension of convertibility in England during the Napoleonic wars, the Bullionist controversy arose between Bullionists (in favor of 100% gold coverage), and anti-Bullionists (who said this requirement of 100% gold coverage is a mistaken view of what money is; it hampers the proper management of the money supply and in the end of the economy).

In the middle of the XIXth century, when the Bank of England was granted the monopoly on the issuance of legal tender bank notes (in 1844), the controversy evolved into the Currency school versus Banking school controversy. The Currency school saying : "banks must keep a high percentage of reserves to cover their deposits", and the Banking school, like the anti-Bullionists, saying: "this is a misunderstanding of what the nature and the role of money are."

The three risks of banking:

1. the imbalance between short term deposits and long term lending: most bank deposits are short term, while their loans are longer term. So there is the risk that depositors, having less trust in their bank, go and demand their deposits back. When this situation becomes extreme, it is called a "run on the bank", and can lead to its bankruptcy
   
   
2. the credit risk: by definition the loans extended by the bank are risky. Some of them will default. When the default rate is too high the bank is in jeopardy. This happens, in particular, when banks have too much liquidities, and are lead to lend to less than highly creditworthy borrowers. This happened in Japan at the end of the 1980's. Then many big borrowers, and in their wake several big banks, defaulted (particularly in the real estate, following the burst of a bubble). It was also the trigger of the Asian crisis of 1997. And it is likely that the present "subprime crisis" (2007-2008), which is much bigger in size than the previous crises, will also have dire consequences on the real economy.
   
   
3. the interest rate risk: usually interest rates paid to depositors are variable (and even when they are fixed, since the deposits are short term, the rates follow the market), whereas interest rates demanded on loans are fixed. When short term rates become very high, they can exceed loan rates. This is what happened in the late eighties and early seventies in the US, and it created large defaults in the Savings and Loans institutions, which required a big federal bail out.
   
   

One million American households have defaulted on their home mortgage payments since the beginning of 2007.

A American family which lost its home in the US in the 1930's

Let's now turn to the balance sheet of the central bank. Historically, the first one was the Bank of Sweden, in the middle of the XVIIth century, and the second one the Bank of England in 1694. Both were created to receive gold to be lent to the monarch to wage wars. A central bank is nothing more than a normal bank which received the monopoly to issue bank notes which are legal tender. So its balance sheet is not essentially different from that of any other bank. But since, the bank notes in circulation have a more official character they are usually recorded at the top of the liabilities, and the corresponding "permanent loans" to the Treasury (i.e. the till of the State) at the top of the assets. The two items don't necessarily exactly match, because Treasury receipts can be created matching reserves (i.e. bank accounts in credit).

Above is shown a typical balance sheet of a central bank. On the liability side we have the bank notes "created by the central bank" and which are in circulation. They were at first "given to the government" (in exchange for the "treasury receipts", on the asset side; in French, "les avances de l'Institut d'émission"; in clear, "la planche à billets", the "bank notes printing press"), and also to buy some new bonds. Then we have reserves that commercial banks are required to maintain at the central bank.

These reserves, recorded as credits on the liability side of the central bank, can come from foreign currencies commercial banks got from their clients and changed at the central bank for local currencies. They can also come from creation from scratch of loans by the central bank to the commercial banks, which will be recorded on the asset side of the central bank as well. This is how the Fed, since the Summer 2007, "injects" money into the US banking system. Since commercial banks, having then more reserves at the central bank, can create more money themselves, this central bank injection has a lever effect on the entire liquidities "injected" in the system.

There are legal requirements about the amount of reserves a commercial bank must keep in its assets (as cash and as reserves at the central bank). A classical exercise is to calculate the effect of a $100 billion central bank injection, if the commercial banks are required to keep, say, 20% reserves at the central bank: in that case the total new money created by the commercial banks will be $500 billion.

On top of these legal reserve requirements in each currency area, in order to harmonize the measurements of banking security ratios worldwide, the Bank of International Settlements, created in 1930, in Basel, defined in the late 80's the Cooke ratios. The main Cooke ratio stipulates that

[ Net worth of the bank / All assets weighted by their risk ] must be greater than or equal to 4%

Net worth = Capital + retained earning

The weights on the assets are:

• cash: 0%
• central bank reserves: 0%
• treasury bills: 0%
• loans: weights between 20% and 100% depending on their risk
  • standard loans to individuals and to firms: 100%
  • mortgage loans: 50%
  • loans to states or municipalities: between 20% and 50%

On the asset side, the central bank has, going from bottom to top, some international reserves (in currencies and in gold), Treasury bonds issued by its government - these are used to carry out open market operations; and the receipts by the government for the issuance of most of the bank notes.

Open market operations are one of the three major levers a government and its central bank have to manage the money supply (i.e. the quantity of money circulating in the country). These three levers are:

1. modify the legal reserve requirements imposed to commercial banks
2. change the prime interest rate paid by the government on short term funds lent to it
3. sell some treasury bonds already held by the central bank (this decreases the quantity of bank notes and electronic money in the country), or buy some treasury bonds held in the population (this increases the quantity of bank notes and electronic money in the country)

The bank notes in circulation + the accounts of commercial banks at the central bank (i.e. the entire liability side of the balance sheet of the central bank) is called the "central bank money", or sometimes "hard money" (see for instance Gurley & Shaw, "Money in a Theory of Finance", Brookings Institution, 1960)

Beyond the apparent complexity of all these bank notes and other accounts, this whole banking system of a country is just a system to control the quantity of monetary means in the economy of the country issued by the various institutions having the capability to create money. These monetary means, we saw, are of several types:

1. bank notes created by the central bank
2. commercial bank reserves at the central bank
3. treasury bills (and other bonds) issued by the state
4. bills of exchange (and other commercial paper and liquid financial securities) created by firms
5. bank accounts in credit at commercial banks (either from deposits of depositors, or by pure bank creation)
6. foreign currency and precious metal holdings
7. etc.

The legal reserve requirements, imposed on commercial banks by the authorities of the country were they operate, just contribute to exert this control on monetary means (i.e. money) creation.

Within the geographical area where their authority can be enforced, governments impose legal requirements on the financial institutions. But three phenomena are tempering these apparently strict protections:

1. there exists banks escaping partially or totally national authorities (banks dealing in so-called Eurodollars, and offshore banks)
2. governments are the least responsible financial agents: central banks were made more and more independent of their government to avoid excessive creation of money via the printing press; but the limitless issue of Treasury bonds, in some countries, is not much different. Treasury and other government bonds are not legal tenders, but they are not liabilities of clearly identified agents either (who would have signed them); they "will be passed onto future generations". (Exercise: guess what will the future generations make of these "agent-less" liabilities ?)
3. new moneys are appearing (which will escape entirely national controls, and be more and more useful)

Some thoughts on money:

We saw that money is an abstract unit of measure of value. And we saw, above, that a central bank "issues" bank notes, which represent rights to buy, of various denominations (10€, 20€, 100€, etc.).

One big problem of such monetary systems is that the purchasing power of the abstract monetary unit (and therefore of the corresponding bank notes, or even the accounts in credit) is not guaranteed to be stable.

Observe that the bank notes in the balance sheet of a central bank are at the same place as the capital of an industrial or commercial firm. In both cases they are on the liability side, and correspond to pieces of paper held by others (the population, for bank notes; and shareholders, for the equity of a firm). In both cases they represent a right to something:

• bank notes of 100€ represent the right to buy something worth 100€, but they say nothing about "what is worth 100€"
• shares of equity of a firm represent the title of ownership of a certain percentage of the firm, and they say nothing about the value of the firm (only the market decides what is the value of one share)

But shares are more concrete than bank notes in the sense that a percentage, say 1%, of a firm is more concrete than 100€, which correspond to nothing concrete guaranteed.

Shares of stock can be viewed as some sort of bank notes that would not be concerned with the monetary problem of stability of the purchasing power of the unit of currency.

Men tried to make units of currency buy something concrete - like shares of stock do - with the gold standard system, where units of currency corresponded to specific weights of gold. But gold is not itself "real value" or something producing value, and anyway any attach to gold was abandoned in August 1971. Since then, currencies are purely abstract.

Quentin Metsys, Le Peseur d'or et sa femme (1514), Musée du Louvre, Paris

Unregulated and off-shore banking

There exist banks that are outside the reach of the regulatory authorities of countries.

As we saw from a theoretical viewpoint in the previous lesson, a banking activity can be started by anyone who owns initial reserves of liquid wealth (and we saw that even the initial "real wealth" is not mandatory, since a central bank's initial capital, for instance, is usually made only of paper bank notes on the liability side, and Treasury receipts on the asset side).

Indeed, since around the XIIth century until the XVIIIth century, banking and finance activities sprang up spontaneously. It was only during the Age of Enlightenment that national authorities began to organise and control their national banking system. Central banks with a monopoly of issuance of legal tender bank notes appeared only in the XIXth century.

In fact the emergence of organized and state controlled banking systems parallels the emergence of nation-states with centralized powers in the western world (France, England, Spain, the United States, Germany, Italy, etc.).

This banking and financial organization reached its climax in the second half of the XIXth century with the gold standard, and the powerful western European nations (England, France, Germany). It is also the peak of the age of modern colonialism, in Africa and the Far East. Students must review the conquest of India by Britain, beginning in the XVIIth century, the split of Africa between England and France, with the near war at Fachoda in 1898, the brutal opening of China in the 1830' and 40's, the Opium wars, and the prying open of Japan in 1854, the colonial policy of Jules Ferry. Students must also review the emergence of the United States, as well as the more or less failed independences in South America in the early XIXth century, the Monroe doctrine, the tentative creation of a Mexican empire in the 1860's by the European catholic powers, etc.

All this lead to the cataclysm of WWI, which marked the end of an ancient world. In some respects, the entire "extended" XIXth century, from the 1780's until 1914, is a "transition period", from a political and social viewpoint, between an ancient regime of centralized monarchies, and modern "democracies". The XIXth century is the century of revolutions, of the rise of "national feelings" (and also the crush of regional particularisms), of the emergence of industrial proletariat, of the first powerful technical achievements of science, of the rise of large scale industrial capitalism, and also of the first large economic depression of an industrial origin (c1870-c1890).

After WWI, the victorious Allies set up the Society of Nations, to harmonize their diplomatic relations, and tried to come back to the gold standard system. They also imposed "Carthaginian" war reparations on Germany which contributed to the burst of the second world conflict. The 20's and 30's were a period of monetary, financial, economic and political instability, with a second great world depression. And the world had to go through another world war before being able to install peace in the West.

The modern post WWII world saw the establishment of a new monetary system set up at Bretton Woods, together with international financial institutions like the world bank and the IMF and political institutions like the United Nations. In the West it was a Pax Americana. And the world lived under the threat of a third world war between the West and the communist block.

After the demise of the Bretton Woods monetary system, in 1971, the world entered a period of currency instability. It was still dominated by the economic and military power of the United States. Since the eighties, the Thatcher/Reagan revolution swung the western world back to societies with less welfare and more tough liberalism. The history of the emergence of nationally sponsored welfare (retirement pensions, health protection, unemployment protection, free education, help to housing, to home owning, and, little by little, to all sorts of things...), beginning with Bismarck at the end of the XIXth century is also a topic students should review in order to get the most from this course in finance, which purports to shed light, from a financial point of view, on the future of the world.

Finally the last thirty years saw the collapse of the soviet empire, the fantastic deepening of the United States trade deficit, the growing disorganization of national finances in many western countries, particularly the US (the "subprime crisis" is only the latest illustration), the emergence of new world powers (China, India, other Asian countries), and also the emergence of internet, which at the same time brings new links between people worldwide, but also erodes subtly and profoundly the power of national governments. All this is preparing a future much different from the past - a future where current nation states are likely to play a lesser role than today.

Original Eurodollars:

It is against this background that appeared, in the 1950's, at the height of the cold war, some new "unregulated" banking activities. In 1956, after the invasion of Hungary by soviet troops to maintain the communist order in eastern Europe (after Berlin in 1953, and before Prague in 1968), the soviets who had dollars assets held in American banks were afraid that the United States would freeze these assets, that is block their bank accounts in credit in the US. So they decided to move their dollars, in the form of paper bank notes and electronic transfers, to a British bank they had in London, the Moscow Narodny Bank, and began to do banking in dollars from their British bank. For instance, "on February 28, 1957, the Moscow Narodny Bank in London put out to loan, through a London merchant bank, the sum of $800 000. This minuscule amount was borrowed and repaid outside the American banking system" (source: Adam Smith (George Goodman), "Paper Money", Dell publishing, 1981).

Dollars used in such banking and financial activities outside the United States, and outside the reach of American regulatory power, are called eurodollars (be they in London, Tokyo or Rio Janeiro).

The Moscow Narodny Bank was not yet entirely "off-shore", it was outside the US banking system, but still paid taxes, in England, on the profits it showed in its books.

More on the original Eurodollars:

The Russian dollars deposited at the British Moscow Narodny Bank were in the assets of that bank, and in its liabilities as a credit to the Russian depositors, as is usual.

These dollar assets were nothing more than dollar bank notes in the vault of the Narodny bank and claims on some American banks somewhere in the United States, that is deposits in American banks, on their liability side again... But the Americans could no longer freeze these dollars, because they belonged to a British bank.

The British bank was responsible for paying, on demand or according to some contract, the Russian deposits.

These Eurodollars were not "new money" in the sense of money created by opening a new loan from scratch on the asset side, like banks regularly do in their national currency, and opening a corresponding credit in dollars on the liability side.

They were equivalent to "liability money"100%-covered by real American dollars in the United States, just like bank notes ("liability money") used to be 100%-covered by gold deposits.

Yet these dollars assets of the British bank were not under the regulatory control of the American authorities. The British bank could do whatever it wanted with them.

Because so far the deposits on the liability side are against 100% deposits on the assets side, and these assets are a currency, and the liabilities are usually remunerated, some authors - like Mishkin - say that Eurodollars are just a variety of Eurobonds. The teacher's opinion is that this view is limitative.

Even less regulated banks:

Some other banks, dealing in big foreign currencies, appeared in authentic tax havens like the Dutch Indies, Panama, and other places like that, called in French "paradis fiscaux". These are even less within the reach of authorities of big western nations.

Off-shore banks do not belong to the organized clearinghouse systems of banks within a currency zone, controlled by a state. They must deal on a private basis with other official banks. For instance when a check drawn on an off-shore bank account is presented to an official American bank, that bank may or may not accept the check (whereas within a clearinghouse system under normal circumstances it must accept checks drawn on the other banks of the clearinghouse). But this problem is more theoretical than real for the reason described below.

In fact, the main clients of unregulated and off-shore banks are large industrial firms and large western banks, who find it handy to have some of their activity carried out outside the reach of their regulatory authorities. For instance, Air France airplanes used to be owned by a (Air France controlled) firm in Panama.

Note that tax havens don't have to be far off-shore. England maintains fiscal havens in the Anglo-Norman islands, and in the isle of Man. Liechtenstein is a tax haven (much talked about in February 2008, because it was "discovered" that many economic leaders, from Germany, France, etc., kept secret accounts there to shirk taxes). Without falling into the trap of populist all-sweeping criticisms, one must admit that "democracy" is more a concept in political science than a reality.

LETS:

There exist other monetary and banking systems, within a country, which are distinct from the official monetary and banking system of the society. These are called Local Exchange Trading Systems (in French, "Systèmes d'échange locaux", or SEL). They are small spontaneous systems of exchange, within a community, which use a unit of count akin to a money. They are tolerated by national authorities as long as they remain small and do not correspond to an important lack of fiscal revenues.

Financial markets

We saw in lesson 1 what are financial products, also called financial securities. We recall them briefly here. There are three ways to pay, in a transaction where we buy goods:

1. with other goods: it is called barter
2. with money: it is the standard way to pay
3. with a promise (of one sort or another) to pay in the future an amount which has "a value today" equal to the price we would pay if we were to pay with plain money

We saw the origin of money and of financial securities. Modern money is actually a variety of financial security (for instance a bank note entitling to gold, deposited in a bank) which has been transformed into a legal tender means of payment on its own.

Financial markets are places where financial securities are traded. Some of these markets have a physical existence and location: the various stock markets in the world. Sometimes, on the other hand, we just refer to "a conceptual market" which is worldwide, where exchanges are carried out on the phone or via computer links, and with no physical location.

The French word for the stock market, "la Bourse", comes from the Vander Beurze house in Bruges. We can find the explanation of this origin, at the entry "Bourse", in the Encyclopédie of Diderot and d'Alembert written in the XVIIIth century.

The New York Stock Exchange

There were already important stock markets in Europe in the XVIth century, in Amsterdam, London, Antwerp, Bruges, some other hanseatic cities, and in France, in Paris, Lyons, Toulouse, Bordeaux, Rouen, etc. Roman historian Titus-Livius (59bc, 17ad) wrote that there was a market place for merchants to exchange goods, perhaps of a financial nature, in Rome in 493bc.

Stock markets were essentially physical locations, in large cities, where merchants, bankers, insurers, and commercial agents of all sorts met at fixed times, on certain days, to do business with each other. Attendance was so important for everyone that the absence of one usual member was taken as a sign that he was probably going through business difficulties and perhaps had gone bankrupt.

For a historical, yet still very actual, description of stock market players, their activities, their mentalities, students are invited to read the novel by Emile Zola, "L'Argent". It is adapted from an episode of French financial history: the krach of the Union Générale in 1882.

Functions of financial markets:

Financial fulfil several functions (adapted from Levinson, "Guide to Financial Markets", The Economist, 2006)

1. Price setting: they enable one to know the market price of something
2. Asset valuation: they enable firms, particularly insurance companies, to know the actual value of their assets
3. Arbitrage: if the same goods are for sale at different prices in different markets (and the transportation costs are insignificant) markets players will buy where it's low and sell where it's high, thereby leveling out prices
4. Raising capital: firms can find needed capital, not only from banks, but on financial markets
5. Commercial transactions: financial market provide the "grease" to commerce. A buyer may pay a seller with a bill of exchange, and the seller may redeem his/her bill for cash, before its due date
6. Investing: people with a surplus of cash can invest it in order to "make it work"
7. Risk management: markets offer the possibility to modulate the risk a player wants to bear or to take on

This last item, risk management, goes back to the earliest of times. For instance, a farmer (A) can sign, in the Spring of a year, at date t, a contract with a market player (B), to sell his crop to B in the Fall, at date T, at a price fixed at date t. The crop and the money will be exchanged at date T, but the contract is signed at t. Such a contract is called a forward contract. It enables A to avoid the risk of price fluctuations between t and T, and to be sure to get a specified amount of money at T. B takes on the risk. We shall meet many contracts involving in a sophisticated way the transfer of risk.

Size of financial markets:

The yearly issues of new securities is given in table 1.1 (from Levinson):

The total issue of new securities (excluding domestic loans that were not resold in the form of securities), in 2004, was $7 trillions. As Levinson says, "estimating the overall size of the financial markets is difficult. It is hard in the first place to decide exactly what transactions should be included under the rubric "financial markets", and there is no way to compile complete data on each of the millions of sales and purchases occuring each year."

Another way to look at the size of markets is to estimate the financial securities outstanding at the end of each year. Measured with this "stock approach" (as opposed to the above "flow" approach), the figures from 1996 to 2004 are:

that is a total, in 2004, of $109 trillions. This is two to three times the world GDP.

The 2007 figure is estimated at $165 trillions. And the major security holders are given in the table below:

(Source : The Economist, 19 January 2008)

Evolution of financial markets since 1980

Financial markets evolved profoundly and grew rapidly since 1980. This is due to the political Thatcher/Reagan revolution which lead to a vast liberalization of various economic sectors, including banking and finance, and to the technological computer revolution which developed financial markets, at the expense of banks.

The movement, in the early 80's, from traditional banking to financial markets is described, in French, as "les trois D's" ("the three D's"):

1. dérégulation (=deregulation)
2. désintermédiation (=desintermediation, i.e. the decrease of the role of banks as intermediaries between investors and borrowers)
3. décloisonnement (=removal of barriers between the various types of financial activities, which used to forbid the same institutions to do several of them at the same time)

The political Thatcher/Reagan revolution lead more specifically to four factors that spurred the development of financial markets (from Levinson):

1. Lower inflation
2. Development of pensions funds
3. Stock and bond market performance
4. Risk management

Lower inflation:

Inflation is a curse on the economy. It disorganizes contracts, rents, repayments, revenues. It has existed at various epochs in the past. Among many others, a famous very long episode of inflation is the "Price revolution" between 1500 and 1650, when prices of various commodities and usual products were multiplied by a factor between 5 and 7 in many European countries.

During the Napoleonic wars, England suspended convertibility of the pound into gold, and suffered from inflation (as is usually the case in war time). A lord named King complained that the revenues from his estates were loosing their purchasing power, and asked to be paid directly with fixed amounts of gold, or to be allowed to modify the contracts with his tenants to increase the rents expressed in sterling pounds. The following illustration helps understand the problem:

At time t, you borrowed £100 pounds from a lender: you received £100 in bank notes and gave the lender an IOU of £100. At that date t, £100 could buy 25 oz of gold. Some time later, at time T, you must repay your debt (aside from the interests which you paid too). At this date T, suppose £100 can now buy only 22 oz of gold. Should you refund £100 to your lender or £113,6 so that he could again buy 25 oz of gold?

Concerning the Price revolution, it is still debated whether it is a consequence of the influx of precious metals from the New world, or rather if it has only accelerated it. Some people even think it is one of the causes of the French revolution, because it transferred economic and social power from the aristocracy to the merchant class.

The opinion of the teacher is that inflation is the symptom of a fine malfunction of the social fabric (in the sense of a tightly knit system), the consequence of which is price increases. When economic science has made some progress, we may identify and measure more fundamental social parameters, on which governments will be able to act. So far, only "common sense" can guide political action ("responsible monetary policy", "restraint in salary increases", etc.); but it often leads to heated political and social debates as to what is better, a strict monetary policy or a social policy? For instance, in the early 20's in England, Churchill complained that the head of the Bank of England preferred to maintain "a strict monetary policy and enjoy a strong sterling pound" than to "address the problem of the 1 million unemployed people". At times unfortunately common sense can be misguiding. It may also mask social struggles and the protection of private interests beneath the cloak of "competence", "complex problems ordinary people cannot understand", etc. Political leaders, as well as central bankers, are often as befuddled as anyone, but they try not to show it. It makes for fun-to-read biographies and memoirs later on, when some witnesses write about the private political meetings they attended.

One of the themes of this course is that one cannot dissociate financial questions from political and social questions. The objective of the course is that students become familiar with the main financial products, their markets, actors, functions, technical aspects, but also with the political and social issues related to them.

There were terrific inflations (called hyperinflations) in Weimar Germany in 1923, and in Hungary in 1945. A creeping inflation all along the 50's and 60's became a severe one in the 70's throughout the Western world. At the end of the 70's it reached 13% in the US, and close to 20% in France.

Hungarian hyperinflation

In 1980, Paul Volker, then head of the US Federal reserve, decided to let short term interest rates go very high with the aim of breaking inflation. Here is a picture of the interest rates in the United State over the last two centuries (it's actually the ten year bonds, but short term rates display a similar curve):

Volker was successful in breaking inflation in the US. Then, with a slight delay, inflation subsided all over the Western world. But if you think of it, this curve of the interest rates over two centuries shows that something tremendous happened in the late XXth century, in the developed world, in financial and monetary terms.

An idea of French inflation is given by the following table of devaluations of the French Franc since Napoleon's "franc Germinal":