Understanding the Money Machine, Ch. 1

Everybody has an opinion on the state of the economy. Virtually nobody has any idea how it works. Not me, probably not you. In an effort to be a little less ignorant myself, I am going to be reading various books on the subject and regurgitating them here. This 90% to improve my own understanding of what of have read and 10% to interest and entertain anyone who stumbles across this blog.

I will be starting with “The Money Machine; How the City Works’ by Philip Coggan.

Originally published in 1986 and now on it’s sixth edition, the book purports to be a comprehensive account of how the UK’s financial sector (the titular ‘City’) works.

As what little I do know of the UK economy is that the financial sector is it’s beating heart, this seems like a good place to start.

Chapter 1 — The International Financial Revolution.

This chapter gives us a birds eye view of the changes in the financial system from the early 70’s until 2010, a time in which it “changed beyond all recognition”.

We are informed that the old consensus was called the “Bretton Woods” system, after post WW2 economic conference and had some features that seem very strange to us today. Of particular importance are;

Fixed exchange rates: So £1 always = $1.50

Strict control on capital flows: Meaning capital (money and assets), could not be moved between countries with ease.

These two things taken together meant currency speculation (betting on the value of a currency) could only be profitable at certain times under very specific conditions and that it was difficult to buy shares in businesses in other countries, reducing the scope for share trading and keeping the market small.

Meaning a few of these, rather than a lot of these

The system broke down for reasons not fully explored in this chapter, but gone into in detail in chapter 15 (stay tuned folks!). What is explained is that the US abandoned fixed exchange rates in1971 of a consequence of the cost of the Vietnam war. Exchange rates now being variable created risks for businesses. Imagine, if pay you for a car to be built with deutchmarks and then sell it in dollars. If the value of Dollars falls against the deutchmark and you have to convert that revenue back you get less than you otherwise would.

Example;

Say £1 = $2

Build a car in the UK for £100, sell it in the US for $300 and you have made £50 profit when you convert the currency back.

However if you build your car in the UK for £100 and while it is on the boat the value changes so that £1 = $3, but the price remains $300, you only make £100 for the car when you convert the currency back, wiping out your profit.

This risk led to the development of financial instruments based on speculation around what a currencies value would be. Companies would buy these to try to protect themselves against future changes.

‘Floating’ exchange rates, as these un-fixed rates were called, also made speculating on the value of currencies a potentially lucrative business in and of itself; especially if you have large volumes of currency to gamble with and can do so at a low risk. This (heavily simplified) is the modern ForEx or Foreign Exchange trade.

The book also argues that in response to political pressure, governments in the West kept interest rates low throughout the seventies, which created massive inflation coupled with unemployment.

Enter Margaret Thatcher.

Thatcher in the UK and Reagan in the US abolished restrictions on the movement of capital abroad and relaxed regulations on the financial sector. With money free to come and go, most domestic share traders found they were too small to cope. In 1986, a rule that brokers were not allowed to advise investors and also trade in shares themselves was abolished. This triggered a rush of investment from the US, Europe and the rest of the world, buying up and consolidating all these smaller traders into larger financial institutions with one of the few domestic successes being Barclays.

The happy pair.

The book then charts the rise and fall of the German and Japanese economies (tightly regulated, less focused on shareholder value) in the 90’s and the rise of the US ‘economic miracle’ from the late 90 through to 2008 (little regulation, revolves more around short term profit) which led most of the world to adopt the so called ‘Anglo-Saxon model’.

Neither an Anglo-Saxon nor a model…

And, as this edition seems to be from 2010, that’s where we end. Little did anyone know how unstable and lacking in resilience that economic miracle would turn out to be…

Next time; we’re done with history and into the the nitty-gritty with Ch.2 Money and Interest Rates