Putting on Financial Goggles

In a poem in The Lord of the Rings, Tolkien writes, 'All that is gold does not glitter, not all those who wander are lost.' It refers to the drifting, scruffy Rangers who patrol Middle Earth, moving openly in the face of power, understanding the signs and signals of the wild, and watching things. Financial rangers need to sketch some basic stylised maps, and to develop some exploration principles, so let's go straight in.

A FIFTEEN-MINUTE MAP OF FINANCE

The British £5 note is inscribed with the words 'I promise to pay the bearer on demand the sum of five pounds.' Money is so culturally engrained in us that we tend to not notice how mysterious that statement is. When asked what a pound is, we might resort to a form of circular reasoning, explaining that it is worth something because other people accept it for payments. In other words, it is simply a claim on goods and services from other people within a certain geographic area. A Brazilian Real has little value to a French shopkeeper. These currencies form the basis of local financial systems, and thus, within the overall global financial system, there is a Russian ruble financial sub-system which can be quite different from the Indian rupee financial sub-system.

Our relationship with money leads us into a relationship with financial intermediaries – such as banks and funds – that offer us services in dealing with it. A typical middle-class individual in a Western country might have access to the following financial services:

• Current account for bank deposits: When she's a teenager, she opens a current account at a high street bank, depositing money that her grandparents have given her.

• Payments services: She uses her bank to transfer money to others with bank accounts. She pays concert organisers for concert tickets. Other people pay her for music tutorials via their banks.

• Foreign exchange services: She takes a gap-year and purchases Mexican pesos from her bank with British pounds.

• Insurance: She buys travel insurance for her trip by paying a premium to an insurance company.

• Unsecured long-term credit: She returns from abroad, and decides to study, obtaining a student loan to pay for the tuition. She doesn't own much, so can't pledge collateral to secure the loan.

• Unsecured short-term credit: She starts working full time, and upgrades her account to include an overdraft facility. She also gets a credit card. Both of these are short-term loan facilities, allowing her to buy things she doesn't have immediate money for.

• Savings and investment: In her late 20s she has extra cash. She wishes to invest it, putting some into a mutual fund that invests in company shares. Her employer also offers her a pension plan, paying part of her salary into a pension fund.

• Secured long-term credit: In her early 30s she borrows money to buy a house, obtaining a mortgage loan from a bank, which is secured on the house.

This is where many younger individuals' association with the financial sector stops, give or take a few more bank accounts, loans and insurance products. The overriding impression is of a one-way relationship with bland retail branches advertising apparently great financial deals, behind which exists an opaque world. To this day, a surprising number of people still believe their money is stored in vaults in banks, waiting to be collected. Few who deposit money in a bank think of themselves as lending the bank money. This pervasive information asymmetry is one reason why banks are able to sell the inappropriate financial products that occasionally lead to mis-selling scandals.

Our personal dealings with 'small finance', though, do provide us with a vital stepping stone to understanding high finance. A huge company uses financial intermediaries for the same things we do, only they do it on a much greater scale.

Financial Sector Meets Real Economy: The First-hand, or Primary, Markets

There is a common distinction made between the financial sector and 'the real economy'. The real economy comprises individuals and companies within industries that produce things like cars, oil, soap and guns, or that offer non-financial services like advertising and entertainment. The textbook view presents the financial sector as a neutral intermediary between such firms or individuals, acting to facilitate investment flows between them.

Investors are people or institutions that have built up excess money they have no immediate use for, and who are looking to put it into economic ventures in exchange for a cut of what those ventures produce over time. They include:

• Individuals with savings: Often called 'retail investors'.

• Companies with savings: Perhaps they've had a good year and have built up cash.

• Governments with savings: For example, Gulf states with large excess oil revenues.

• Institutional investors: Huge funds – such as pension funds and sovereign wealth funds – that collect and pool these savings in order to invest them on behalf of individuals, companies and governments, often by parcelling the money out to the fund management industry (which includes, for example, mutual funds, hedge funds and private equity funds).

Our society is also full of 'investment opportunities' created by individuals or institutions that need money in order to engage in production, exchange or consumption. They include, for example:

• Small businesses that need start-up capital.

• Large companies that need money to expand operations, or to ship goods abroad.

• Multinational corporations that need money to acquire a competitor.

• Governments that need money to build a high speed railway, or to fight a war.

• Individuals who need money to buy a house, or to study at university.

Investors with savings invest in such investment opportunities. If an investor exchanges money in return for an ownership claim on a venture, they are engaging in equity investment – for example, your friend is trying to start a design company, so you invest in it and become a co-owner. If an investor exchanges money in return for a debt claim that entitles them to interest repayments, they are engaging in debt investment – for example, you lend a local farmer in your village some money, thereby indirectly investing in their productive activities.

Much investment though, takes place via intermediaries, and this is where banks fit in. Commercial banks, for example, facilitate debt investment by taking money from individuals and institutions, and using that as the basis from which to extend credit to borrowers in the form of loans. Commercial banks are connected together via a central bank, which...