My money, Your money

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There are only two types of money in this world. One is “my money” and the other is “your money”. In corporate finance, the former is called “equity” and the latter is called “debt”.

How efficient is my money utilized? Namely how much return per one unit of “my money”? The formula is given as return divided by “my money” (equity), so called Return of Equity (ROE).

There are only two ways to improve ROE, to increase the return or to decrease the equity. The latter can be achieved by utilizing “your money” i.e. borrowing your money, so that the share of my money per return will decrease. Then I can claim, “I am using my money efficiently”.

Quick question. I lend you 100 dollars and you lend me back 100 dollars. Is it my money or your money?

Technically, it’s your money. The 100 dollars are on my hands now but obliged to pay you back in future, as it belongs to you. I am just “borrowing”.

So… now I know it is your money… (My personality suddenly changes). Who cares about your money! I am the risk taker! Let us put your money into a risk asset such as sub-prime. (10 sec….). Oops, no money left to return “your money”, but can you pay me back “my money”?

In MBA, the place we can learn about the current “Capitalism”, being taught the virtue of borrowing money, and draw the clear line between your money (debt) and my money (equity), lacking a holistic view.

Yes, money must be used efficiently, and CAREFULLY regardless of my money, your money.

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Investment bank as wealth transfer vehicle from shareholders to traders

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No matter how much traders make loss, their risk exposure is limited. For the worst case, they just get “fired”. No obligation to compensate for the loss. This position is so called ”owning put ” in a financial term, as their loss is floored but profit has no cap.

Therefore, it is reasonable for traders in an investment bank to leverage out the company’s capital to take more risks.

But, then who compensates their loss in this “zero sum game”? The answer is stakeholders of the investment banks.

If this business is lucrative, why they become public companies after a hundred years of their history? Not to continue to be partnership that allows partners to own their profits?

I think the reason is, the original investment banking businesses such as advisory on mergers, fund raise were indeed lucrative, so that it becomes extremely competitive. As a result, investment banks have become investing banks with high-risk exposure and it was a rational decision to let the companies go to be public to realize capital gain.

The hindsight is always fifty-fifty

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A Vision for Bretton Woods Two - Removing systemic risks by reforming to the system based on debit settlement, not credit

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The problem of the current economic system is the systemic risk embedded with credit settlement. To increase demand, each participant pay by credit, which means “I OWE YOU”(IOU). Others can use this IOU as asset, so that the owner of IOU could expand his/her credit further based on this IOU.

In this way, IOU is money and each time participant pay by credit, contributing to “money creation” and chaining one’s credit to another.

The worst comes when the last chain connects to the first. The credit of participant relies on the one of another interdependently, results in domino structure causing the systemic failure such as the current financial meltdown.

On the other hand, when people settle by debit, there is no space for IOU and each transaction is closed not to impact one another. There is no systemic failure to be triggered with debit.

With the economic system of debit settlement, we cannot stretch out our purchasing power by credit, which means less demand in the economy. The only way to increase the demand is to increase the velocity of money circulation. That is to increase the number of transactions with the given amount of money.

The profile of the new Bretton Woods Two is yet to be known, however, it is clear that the next bubble is inevitable as long as the demand relies on credit expansion. And the country in a position to expand credit will have the strongest economic power again in the global economy and the next ground zero of financial meltdown.

Reference:

http://www.boj.or.jp/type/exp/seisaku/expkess.htm

Note:

This article has been posted to newspapers, and no reply. Thereby posted to my blog here

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