I think the first principles of anything are really important. This is especially so with money and finance, because you’ll find that any really complicated structure can be distilled into a few of the basic ideas put together. Consequently I am going to start right at the beginning.
In pre-historic times people used to swap things that they had made in order to get the things they wanted. For example if I made axes, I might trade one in order to get a chicken from my friend Alex. This is called bartering. But what do I do if Alex doesn’t want an axe? Then I might need to first trade with my friend Ed who will swap my axe for a cloak, which I could then use to trade for a chicken. You can see things getting complicated pretty quickly.
Inevitably some goods became more commonly used as a means of exchange. These goods were usually small, hardy and difficult to come by naturally — for example semi-precious gemstones. So now if I wanted a chicken, I wouldn’t be relying on Alex to need an axe for us to trade. I could exchange my axe for ten gemstones, and Alex could accept these in exchange for a chicken. In this example the gemstones are money, acting as a means of exchange.
Money is whatever people accept as money. It’s a bizarre concept, but the entire system relies on confidence that if you accept payment in a particular form you’ll be able to pay for things yourself using that form. In the example of the previous paragraph, Alex would only accept my gemstones as payment if he was confident he could use them to pay for something else. In prisons where individuals don’t have access to banknotes, prisoners use cigarettes as money. There are numerous historical examples also where ‘black markets’ have sprung up using cigarettes or other goods as a means of exchange. Using money is human nature.
So what’s a market? It’s simply a place where buyers and sellers interact, using money as the unit of exchange. Imagine in some ancient Greek village, the local market was the place where potential buyers met with sellers of goods (e.g. fruit, grain, funky togas) to buy and sell.
The price of any particular good is whatever a buyer and seller in a market agree upon. In our ancient Greek village a buyer and seller must agree on the price for the funky toga. In a modern context we’re used to seeing goods offered for a fixed price in high street shops, but this still relies on the buyer to accept that price.
Many, many interactions can be described as markets. If you’re selling a house then you’re a seller in the housing market, looking for a buyer. If you’re looking for a job then you’re really selling your labour, for which a company will hopefully decide to buy and employ you. Your salary is simply the price for your labour. When people talk about financial markets they’re referring to the interaction of buyers and sellers who are transacting different types of financial instruments. I won’t write about what financial instruments are here, but the dynamic of a market remains the same.
There is a market for money too. The buyers of money are those who really need some; for example if Alex wants to buy a car. The sellers of money are those that have too much for their present use and need to invest, for example Ed who recently sold his business. Ed will give Alex $100 in exchange for Alex promising to pay back $110 in a year’s time. This is a loan at the interest rate of 10% per year. In other words it is an interaction where Ed “sold” some money to Alex at the “price” of 10% per year. It’s weird, I know.
Where do banks fit in? Banks take in money from depositors and lend money out to loan-holders. They are the “buyers of money” for their depositors, to whom they pay interest as the “price” of that money. They are the “sellers of money” to their loan-holders, to whom they charge interest as the “price” of that money. Banks, in their simplest form, are simply buyers and sellers in the market for money.
Banks make profit by charging more for the money they lend out than they pay for the money they get in. If I deposit $100 at my bank it might pay me 1% per year, so in a year I’ll have $101. At the same time it might loan out this same $100 at 5% per year to Alex so that it will receive back $105 in a year. When the bankers do their sums at the end of the year they paid out $1 and made $5 for a profit of $4.
Each of the concepts I’ve written about today (money, markets and banks) deserve much longer explanations, and I’ve only touched upon the simplest definitions of each. The key takeaways are:
- Money is whatever people accept to exchange value;
- Markets are places where buyers and sellers of a particular “thing” interact; and
- Banks are both buyers and sellers in the market for money.
Why is this theory important? If you don’t understand the fundamentals you’ll never have a solid base from which to make your own money decisions.
Get excited — next week we’ll be tackling a budgeting method for people who suck at budgeting!
Oliver is a banker who has an ambition to help millennials learn the adult skills they never got taught. To follow his journey head to his medium page here.
If you have questions then please email or comment and Oliver will do his best to answer.