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Archive for the ‘finance’ Category

This past week’s This American Life podcast is called “The Invention of Money,” tackling what host Ira Glass calls the “stoner-ish question” of what money is.

 

 

In the prologue, the discussion revolves around the confusion a reporter feels when during the peak of the financial crisis in 2008 he heard news reports of billions and trillions of dollars disappearing from the stock market. How could money just disappear, he wonders; where did it all go? His answer, which he receives from some businesswoman aunt, is that the money never existed because money is “fiction.” Cue soundtrack from The Social Network.

The podcast proceeds from this conclusion, and while the episode is entertaining the content fell short for me as a result. The main mistake is to think of money in terms of a) only coins and bills, and b) only as a medium of exchange. The reason billions of dollars can disappear from the stock market is not because the physical currency was “fictional” but because money in this case is serving as a measurement of value (the economics term is the not-so-descriptive unit of account). And value, like beauty, is measured subjectively. If I intended to buy 5 pounds of potatoes but only went home with 3 pounds because the grocer’s scale was off, it’s fair to say 2 pounds of my potatoes have become fiction. If I go home with £5 of potatoes today and discover that I can only sell them for £3 tomorrow, however,  the two pound difference is reality.

In Act One, the fiction line is cast to Brazil, where its currency switch in 1994 to the real is framed as grand scheme that successfully duped the people into thinking the new money had value. This misses the real magic, which is something more akin to the food fight scene in Hook:


The real had value not because folks believed in a lie, but because they trusted the government and each other that the new currency could be used to exchange for things they wanted. When the people acted as though the bills and coins were money, they became so; the real became real.

Act Two, which is my favorite segment of the bunch (and not just because of the title), does a good job of explaining the Federal Reserve vis-à-vis the financial crisis. I especially liked how they avoided the typical journalist mistake by explaining that the Fed works with the money supply, and not interest rates directly. My quibble here is that they give listeners the impression that only a central bank can create money,  when in fact any bank in the world that loans out some of its deposits (i.e. fractional reserve banking) is doing the same thing, just on a smaller scale.

For the non-pedantic non-economists among you who nonetheless find interest in the inscrutable nature of money, do give it a listen. You may also enjoy revisiting this short but content-packed interview with Niall Ferguson on the Colbert Report from a couple of years ago.

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In times troglodytic, folks had to barter to get what they wanted. This form of economy was more efficient than doing it all yourself, but it was still considerably constrained by the coincidence of wants. That problem was solved by using money as a medium of exchange, which made transactions far more efficient by freeing them from the need to match up wants. Money also loosed exchange from the bonds of time: those with extra money today lend to those with too little, with interest as the compensation until the principal is repaid.

This last component came to mind often in several meetings I attended last week. Rwandan coffee output is lower this season partly because growers are having difficulty securing loans. The growers incur large costs at the start of the season, but can only afford to pay the costs at the end of the season when they’ve sold their harvest. Bridge financing would solve this mismatch between expense and revenue, but because the exchange in this case must be limited in time, the coffee grows unsold.

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Today Felix Salmon highlighted some Chuck Norris facts pertaining to his experience in banking:

# Little-known Chuck Norris Fact: Chuck Norris does not mark to market. The market marks to Chuck.

# More: Chuck Norris does not go bankrupt. Chuck Norris ruptures banks.

# Source of hedge fund survivorship bias?: Funds that pay Chuck Norris 2 and 20 survive; others don’t.

# Private equity: Chuck Norris does not believe in leverage. Chuck Norris believes in crowbars.

# Investment banking: No-one defers Chuck Norris’s compensation.

# Capital structure: No-one subordinates Chuck Norris. All his equity is preferred.

# If Chuck Norris devised the bank stress tests, not even the Treasury Department would survive.

Felix then invited readers to submit their own in the comments, so I gave it a shot and came up with these:

  • Chuck Norris’ tears would solve all the banks’ liquidity problems. Too bad he’s never cried. Ever.
  • Chuck Norris is too big to fail.
  • Some think deposit insurance is what prevents a run on the bank. It’s not–it’s the fear that Chuck Norris is lurking in the vault.
  • Basel rules stipulate that if Chuck Norris is within 100 feet of a bank, he can be counted as Tier 1 capital.
  • The risk-free rate is not computed using US treasuries, but the length of time it takes Chuck Norris to complete a roundhouse.
  • Chuck Norris doesn’t target interest rates, he pummels them into submission.
  • Whenever Chuck Norris visits a country, yields on that government’s debt fall 150 basis points.
  • Only Chuck Norris can issue secured debt. The rest is at his mercy.
  • Beta is just a measure of Chuck Norris’ mood.

They are admittedly geeky, but they were funny enough to get a shout-out by Felix. My 15-minute joy was tempered, however, when a banking friend forwarded along this article from September 2007:

A famous series of jokes uses the actor Chuck Norris, martial artist and star of “Walker, Texas Ranger,” as a paragon of masculinity and omnipotence. ..

Similar thinking can be applied to the current state of financial markets. Here, then, is the world of money recast in Chuck Norris terms.

Chuck Norris doesn’t target inflation. He roundhouse-kicks it until it begs for mercy.

(…)

The tears of Chuck Norris would supply enough liquidity to solve the credit crisis. Too bad he never cries.

I’m pretty sure I never saw this article before, so I plead innocent to plagiarism. The real sting comes from realizing that my humor wasn’t quite as original as I thought it was. Of further humiliation is that the tears I’m crying now are good for nothing. *Sniff*.

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Mental Exercises

After running about 25 miles a week for my last few months in Germany with only minor physical problems, my left knee gave up the ghost on just my second American jog in late July. Since then, and much to my consternation, I’ve only been jogging a few times and even then just for two or three miles before my knee began hurting and gave me grief for the rest of the day.

Since jogging is not an option until my knee is rehabilitated, I decided to join a gym for my fitness jollies, but only got around to it today when I started a free week-long trial. At the end of the week, I must decide on a pricing plan, and am confronted with several options (Yes, the gym is pricey, but it’s my only choice given my preferences):

Plan 1- A 12-month contract consisting of a single $99 program fee and a monthly payment of $59
Plan 2 – A 3-month contract consisting of a $225 payment ($75 per month)
Plan 3 – Pay a month at a time for $85

Plan 1 can be immediately eliminated since I won’t be in Columbia for another year. I will most likely be here for at least three months, however, so Plan 2 seems a good choice as it is $30 cheaper than Plan 3 (85*3=255). Problem solved?

No!

Though the calculation above is where most folks would stop, my finance professors would be insulted if I ignored the structure of the payment! A lump sum payment of, say, $100 today is only equivalent to 10 monthly payments of $10 in a world with no interest, and this is not the world in which we live; money has a time value.

Thus, I must reevaluate Plans 2 and 3. While Plan 2 is cheaper on a monthly basis, it requires me to pay out the money up front. Plan 3, on the other hand, affords me the ability to make smaller monthly payments, which in turn allows me to earn interest on the cash I would have already spent if I had opted for the lump sum. How much interest I expect to earn thus become the key to making a wise decision.

Assuming I could earn 5 percent annually (somewhat heroic, given current conditions), the sums would be as follows (I’m also assuming monthly compounding):

Plan 2 – Since I’m spending all the money up front, there’s no time component here; the plan will cost $225
Plan 3– 85 + 85/(1+(.05/12)² + 85/(1+(.05/12)³ = $ 253.25

Yikes. With a five percent annual rate, the interest I earn on Plan 3 would only defray $1.75 of the cost. Under these circumstances, Plan 2 remains the best bet.

An interesting question remains: How much interest would I have to earn to defray the extra cost of Plan 3? I’ll spare you the calculation, and simply tell you the answer is about 97 percent, or 8 percent per month. If I could earn that rate, the interest earned would defray exactly the extra costs of Plan 3, and I’d be indifferent between it and Plan 2.

Of course, if I were earning a 97 percent annual return, I probably wouldn’t be poring over the minutiae of gym membership plans.

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The UEFA President wants all to know that sport is special:

Sport is not an economic activity like any other. Sport is about sharing, surpassing oneself, exchange, respect. Sport is about emotions. Football is a game rather than just a product or a market. It is a spectacle rather than just a business.

Replace “sport” and “football” with “painting” or “programming” and one sees how meaningless of a statement this is.  Indeed, an “economic activity” is virtually defined by the very terms which are proffered forth to except it from so cold a classification.

If President Platini would have used “financial activity” instead of “economic activity,” I would be closer to agreeing with him. Finance, like economics, is built upon notions of human behavior for its theories, but finance concerns itself almost exclusively with money, and this narrow focus seems to be the thing to which the President takes umbrage. I still think the sentiment would be misguided, but  it would at least be a bit more on target.

Unlike Jewel, if I could tell the world just one thing,  it would be that economics is far too rich a subject only to concern itself with money.

HT: CI of E

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Balancing Act

Sometimes all it takes to swing from loss to profit is the stroke of a pen:

Changes in accounting rules allowed Deutsche Bank to avoid a loss for the third quarter.

The new rules enabled the bank to reduce its write-downs by nearly $1 billion, giving it a net profit of 435 million euros, or $573 million. Analysts had widely expected a loss.

Many people have a perception of accounting as being a tedious but straightforward and formulaic process, but the truth of the matter is that accounting rules are necessarily based on subjective assumptions; whether a company realizes a loss or profit can be entirely dependent on nothing more than how it is thought things should be accounted for.

This idea became clear to me when I thought about the accounting I do for my own budget. Let’s say that in December, for example, I make a big purchase with my credit card such that I spend more than I earn in the month. Since I made the purchase in December, I could record the expense in December and realize the loss. However, because I made the purchase with my credit card, I’m not actually spending any money until when the bill comes due in January, so I might choose to log the expense when I pay the bill rather than when I made the purchase. If I choose this second option, I’ll realize a profit in December rather than a loss, and the only difference was how I recorded the expense:

Option 1

December

January

Income

1,000

1,000

Less Expenses (350 on Credit)

1250

600

= Profit/(Loss)

(250)

400

Option 2

December

January

Income

1,000

1,000

Less Expenses  (350 on Credit)

900

950

= Profit/(Loss)

100

50

Deutsche Bank, probably mindful of Enron and Germany’s high intolerance for perceived corporate duplicity, did to its credit make certain in its statement to make clear the profit was due to a rule change:

Deutsche Bank reclassified certain assets, for which no active market existed in the third quarter and which management intends to hold for the foreseeable future, out of trading assets and assets available for sale and into loans. If these reclassifications had not been made, the income statement for the quarter would have included negative fair value movements relating to the reclassified assets of 845 million euros.

My example is not strictly analogous to what Deutsche Bank did (which has to do with this), but I’ll save that lesson for another time.

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I was surprised to discover some weeks ago that Germans pay out the most in taxes among rich countries in the OECD (at least in terms of income tax and social security payments):

Perhaps my surprise was unwarranted, however, since my own pay stubs provide all the evidence I need. Currently I pay about 22 percent of my monthly earnings in taxes, a tremendously high rate considering how little I earn. What’s more, about half of my taxes (≈10 percent of my income) goes toward social security. I tend to disagree with a government forcing me to save at all, but I find it especially laughable when I’m forced to pay for benefits I will never receive (I’m not planning on retiring in Germany, after all).

To be fair, I can make a claim for a refund when I return to the US, but even that is the equivalent of providing the German government with an interest free loan. One wonders how this practice could be considered anything but unethical in view of the fact that I am coerced—ultimately upon threat of violence—to contribute. Alas, that is simply the nature of the beast.

More worrisome for me at the moment, though, is that my taxes went mysteriously up by about 1.5 percent between February and March. Something pernicious is undoubtedly afoot…

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