This is going to be my final model (woop woop). I’m calling it Intermediateland, because in Intermediateland they’ve invented financial assets, and financial assets do actually intermediate between savers and borrowers (in the manner that economics textbooks incorrectly suggest that banks do).
Intermediateland offers Bob the saver an interesting and exciting array of financial assets that he can purchase with his savings, as a way to hopefully preserve and increase their value, such that when he sells the asset he can purchase with the proceeds more goods or services than if he had just left the money in the bank.
So to understand the Intermediateland model, first we need to understand financial assets. An asset is anything of use or value that an individual or organisation owns. Most companies own physical objects that are necessary to run the business – offices, factories, shops, machines etc – these are assets, and known as “fixed capital”, as I’ve covered before in the post on Investment. If we are talking loosely we would call a financial asset an “investment” in another company or institution, or a loan to another company or institution. I say ‘talking loosely’, because I’ve been at pains in the past to emphasise that in economic terminology investment means purchase of fixed capital or increase in inventories, but its wider meaning in everyday language spills over into economics all the time.
When we talk of “investing” in another company, or indeed of financial assets in general, the man-on-the-street probably thinks of stocks and shares, and these are likely to be used as the example in a textbook. In Intermediateland, rather than depositing his savings in a bank, Bob can directly buy a share of a firm. This is not a loan, but like a loan, selling shares enables firms to raise money up-front for investment. The benefit to the firm is that they are not committed to making any regular payments – if times are hard they don’t need to pay anything. But if the business is making a profit, then shareholders will expect their share (obviously enough) and the payment of those dividends is a liability of the firm.
But stocks are far from being the most important form of asset. The extent of focus on share prices in the media is actually a distraction from the importance of the full range of assets that exist. Most financial assets represent a form of loan. You will no doubt be used to bank loans and mortgages, where the bank lends you money, and you pay the money back in regular instalments along with the interest. The loan to you is an asset of the bank: on their balance sheet, the money you owe them is recorded as an asset.
But there are many other ways that loans can be structured, including government and corporate bonds and commercial paper. Typically, these structures involve a regular interest-only payment (though often not called interest), with the original principal amount of the loan only being repaid when the bond expires (like an endowment mortgage). I’m certainly not going to get into the detail of how all these assets work or this will become very long and boring (for you, not for me – I love this stuff). Just be aware that there are lots of different types of debt instruments – be aware that there is a whole world out there that you probably don’t know much about and is very important to the functioning of the economy.
Sometimes the relationship between the buyer and seller of an asset is direct – you buy the bond, the company receives the money, and your savings now become available to the company to spend. But more often, there is a dealer in the middle, such as an investment bank. The dealer buys a range of assets from those looking to raise funds, and then sells them on to savers. Intermediation is still taking place, but is indirect. When an asset can be easily traded in this way, it is called a security. To put that another way, when you hear on the news about securities, they are referring to any financial asset that can be traded.
That is the briefest overview into the world of assets, but hopefully sufficient to explain the essential point about them: generally speaking, these financial assets “intermediate” between savers and institutions that are seeking credit, in the way that economics textbooks describe banks doing. As we’ve seen (and will look at in more detail in a few weeks) banks do not in fact intermediate by lending out people’s savings. But asset markets do intermediate, and banks do play a role as dealers in these markets. This intermediation is a vital part of the economy that it’s important to understand.
At the risk of repeating myself, although we would typically talk of “investing” in financial assets, it’s important to start thinking of this as saving. We talk about assets as something that you purchase or buy, and we might think of saving as not buying things. But when you buy a financial asset you do not consume that asset, you simply continue to own it. Remember that saving is defined as the difference between disposable income and consumption expenditure, and assets are not consumed. Expenditure on a financial asset is a form of saving. The purchase of the asset may lead to investment – e.g. by the company selling the asset, or by a company at the end of a chain of asset buying and selling – but it does not always do so. We will cover these different circumstances next week. So try not to think in terms of “investing” in assets, or assume that the purchase of a financial asset always leads to investment in the end. Indeed, buying shares almost never leads to investment. If a company sells new shares it will probably use the proceeds for some form of investment, but the vast majority of stock trading is the sale and purchase of already existing shares. No investment (and no intermediation) happens as a result. Purchasing a financial asset is a form of saving. I know I’m going on, but it’s important that you’re clear on this. Are you clear?
When Bob buys an asset he is not spending his income on consumption – instead, he is putting off consumption in the hope and expectation of being able to consume more in the future. He can save by buying stocks and shares, by buying Government bonds, or by buying a whole range of financial assets and derivatives.
Next week we will look at how plugging financial assets into our engine affects the behaviour of saving, as we have done every time I have introduced a new model, remembering that when you purchase an asset you are saving – or did I already mention that?
