Borrowing Through The FINANCIAL MARKETS
We never know whom we might encounter on our leisurely stroll through the economy. Passing by the marble columns of Interstate OmniBank -- the beacon of safety and security -- we have the good fortune of crossing paths with our Ivy-League-educated pillar of the financial community -- Winston Smythe Kennsington III. Although he seems to be a touch condescending, he's kind enough to show us a freshly signed check for $37 gadzillion, which is but a small part of a multi-gadzillion dollar loan from the Interstate OmniBank. To what constructive purpose Winnie will put these funds remains unclear; how this loan will be repaid, he never says; but Winnie proudly reminds us several times that this loan once again proves his unchallenged standing as the majordomo of the financial markets.
The Tools of the Trade
Before we get into the ins and the outs, the nuts and the bolts, the nitty and the gritty of financial market exchanges, it's worth a moment or two pondering the basic stuff exchanged through financial markets. To do this let's divide our economy into two piles:
- Real stuff. This pile includes our physical goods and resources -- labor, capital, natural resources, and the output that they produce. In other words, our economic pie.
- Financial stuff. This pile includes the legal claims on the physical goods and resources -- such as corporate stocks, bonds, and money. That is, the pieces of paper that show who owns our economic pie.
The first pile of stuff is real because, well, it's real -- you can hold it, touch it, taste it, see it, and smell it. It's also what satisfies our wants and needs. It's value depends directly on consumer satisfaction.
The second pile, representing legal claims on the economic pie, especially ownership of it, is what we trade in financial markets. The value of any of the financial stuff ultimately depends on how well the real stuff satisfies consumers' wants and needs. For example, the value of one share of Omni Conglomerate, Inc. corporate stock isn't worth the paper it's printed on. It is, however, worth the productive capability of Omni Conglomerate, Inc.
Bringing Buyers and Sellers Together
The purpose of financial markets, the very reason for their existence, is to bring buyers and sellers together. This, of course, isn't an Earth-shaking revelation. The purpose of any market is to bring the buyers who want stuff together with the sellers who have the stuff. Rather than tacos, lawnmowers, or ice cream scoops, the stuff of financial markets are the legal claims on our economic pie.
So who does the buying and selling in financial markets?
- Buyers are lenders. A straight-forward view of financial markets would tell us that the demand-side includes those who want to gain possession of these legal claims, much like the demand-side of the taco market includes those who want possession of tacos. But there's a little more to the exchange. When you buy a legal claim you're also lending money to the financial market. For example, buying a government security is really making a loan to the government. Any spare change that I deposit into a savings account also means that I'm buying a legal claim from the bank -- their promise to return my money.
- Sellers are borrowers. If buyers provide the funds, then sellers in financial markets must be getting them. Those who sell legal claims, like banks with their consumer savings accounts, or government and the securities it uses to finance the federal deficit, do so as a way to borrow money.
Here's where we get to the very reason for financial markets -- gaining access to money. The buying and selling of legal claims is really a secondary part of financial market transactions. Those who sell financial claims, don't want to sell financial claims so much as they want money. While you might argue that money is just another lump in the pile of financial stuff, it stands alone as something that can be used easily and quickly to buy any of the real stuff that makes up our pie. You can't say that for other legal claims. (More on this intriguing point can be found under the definition of money in section III.)
For example, suppose Interstate OmniBank is willing to give me the cold, hard cash that I need to buy a brand new car. All I have to do is sign a piece of paper promising to repay them at some time in the future. I sell this legal claim, Interstate OmniBank buys it, I get the money, and I buy a new car. Pretty nifty, eh?
Big Piles from Little Piles
Many financial markets not only move money from lenders to borrowers, they usually help to accumulate the money into big piles. As we'll see in a few paragraphs, those who borrow money usually need a lot, and I mean a whole lot. Any given borrower might need a gadzillion dollars to build a factory, finance the federal deficit, or something similar. Most lenders, however, don't have a gadzillion dollars to lend. The hard-working, taxpaying members of the third estate who do most of the lending, are lucky to come up with thousands to lend, let alone gadzillions. Financial markets, therefore, help to accumulate the funds from a bunch of people, each with a little bit of money, before making large sums available to those who borrow.
That, in fact, is the primary function of banks. While you might think that the most important goal of financial beacons like the Interstate OmniBank is to keep you deposits safe and secure, it's not. Their primary goal is to get a little bit of money from a lot of people that they can loan out in the gadzillion dollar category to the likes of Winston Smythe Kennsington III. Safety and security is simply part of the price banks pay to get your money.
Why Borrow? Why Lend? Why Not?
Okay, let's consider a few specifics on why borrows borrow and lenders lend:
- Suppliers of funds. Those who supply money to the financial markets do so for two reasons. (1) They want to store money that they can spend on something at a later time, such as on a college education or a factory. (2) They are enticed by an interest payment, dividend, or expected increase in the value of the legal claim.
- Demanders of funds. Those who borrow money do so because of some intended use. We already noted that the federal government wants (I should say needs) money for the federal deficit. Likewise consumers often want to buy stuff like houses or cars, but don't have enough money readily available. Businesses also borrow for investing in capital goods and do so because they expect this to generate profit.
This last part about investment is among the more important for our economy. Investment in capital goods helps our economy by expanding the size of our pie, producing more stuff, and doing all sorts of other good things that come under the heading of economic growth. If financial markets didn't make it so easy for businesses to accumulate the funds needed to invest in capital, we would have a much, much smaller economic pie.A Financial Market Smorgasbord
While we're all very familiar with the face of Winston Smythe Kennsington III from the society pages of the newspaper, he is most comfortable among the financial pages. Like most newspapers, the financial pages of Winnie's paper reports on the transactions and prices that are the lifeblood of any financial aficionado.
By far the most prominent financial market commonly covered by newspapers is the stock market. There are, however, also financial markets for corporate bonds, government securities, municipal bonds, mortgages, foreign exchange, and legal claims on such things as gold, silver, petroleum, and assorted farm products. While its easy to short-circuit your brain over the array of financial markets in our economy a few classification points can reduce the confusion:
- Equity and credit. Some financial markets deal in equity while others in credit. Equity is the actual ownership of something -- the most common example being corporate stock traded over stock markets like the New York Stock Exchange. Credit, in contrast, stems from a loan, which is simply the promise to repay borrowed funds. The most common credit markets trade government securities, corporate bonds, or municipal bonds.
- Spot, futures, and options. Spot markets are those that exchange an actual "something" between buyers and sellers. The stock market is not only an equity market, it's also a spot market -- a spot, equity market. Futures markets, in contrast, exchange the right to buy or sell "something" at a specified price and at a specified time in the future. Although you might not think of spot markets for farm products and petroleum as financial markets, the futures markets for these sorts of goods are. Options markets are much like futures markets, but instead of setting up an actual exchange at some later date, you only set up an "option" to buy or sell stuff. You don't have to go through with the buying or selling if you don't want.
- Money and capital. We can also divide up the credit part of financial markets into short-term and long-term. Short-term loans that are paid off in less than a year are part of the money market, and include such things as treasury bills and commercial paper. Long-term loans that are paid off in more than a year, often up to thirty years, are traded in capital markets, and include Treasury bonds, Treasury notes, municipal bonds, and corporate bonds.
More than the Financial Pages
A whole bunch of the financial stuff in our economy never makes it to the newspaper pages. Because the financial pages are news oriented, they report on those markets that either are open to a lot of buyers and sellers or are some key indicator of what's going on in the economy.
A few examples of unnewsworthy financial stuff is also in order:
- Banking. You deposit some spare change into your savings account, make your monthly mortgage payment or use your credit card to purchase a few essential items from Mega-Mart Discount Warehouse Super Center. All of these activities place you four-square into the middle of financial markets.
- Insurance. You expand your life insurance coverage or get sick and make a claim on you medical insurance. Once more, the financial markets and legal claims come into play.
- Money. You remove a crisp, new dollar bill from your pocket and after admiring the portrait of George Washington spend it on a Waldo's Super Deluxe TexMex Gargantuan Taco (with sour cream and peppers). Guess what? That dollar bill is also part of a financial market.
The Winston Smythe Kennsington IIIs of our economy aren't the only ones who spend a lot of their time in the financial markets. Sure, he may be able to add gadzillions of dollars to his wealth each day through the financial markets, but these markets are equally important to consumers of the third estate. We would all find it very, very difficult to function as consumers, workers, and (unfortunately) taxpayers, without financial markets.