Today’s modern financial system is built on one thing and one thing only: trust. We trust the people behind the governments who issue money. We trust the banks who loan money out, far out-leveraging their own assets. We trust the managers of companies that use the loans to build assets – we trust that they will be able (for the most part) to build assets to pay back those loans. We trust that the economy of the world will continue to get better and all those assets, behind all those loans, will bear fruit and the loans will be repaid. But what happens if that doesn’t happen? What happens if the trust gets broken? And should you be prepared?
To understand why trust in all the actors in the world’s financial markets is important and why this notion that things will get better in the future is critical, let’s first look at how money is created.
Let’s use a super simple example of a fictitious world called the United States of Everywhere, which uses dollars as its currency.
In our world we have one Bank, called Capital First. Capital First has just opened its door for business. We also have a builder, called Bob, who has 1 million dollars thanks to years of hard work building houses for everyone in the United States of Everywhere.
Bob is looking for a safe place to store his money. Capital first seems like a great place and Bob is convinced of this after his conversation with the Bank’s Chairman. Bon deposits his 1 million dollars into the accounts of Capital First, much to the delight of its Chairman.
Along comes Casey who has a great idea to build a hotel on the beautiful and pristine coastline of the United States of Everywhere. He contacts Bob who says he will build it for 1 million dollars. Casey asks Capital First for a loan of 1 million dollars and then pays Bob. Bob deposits the money into Capital First and gets to work.
Capital First’s Chairman is even happier. His accounts now show 2 million dollars of deposits and one loan due of 1 million dollars.
More people, hearing of the new bank and this new thing called credit come rushing to the bank with their investment ideas. Capital First’s Chairman approves another seven 1-million dollar loans for similar hotel projects. The Chairman is enthusiastic about his start to the year.
Bob is also happy as he has another 7 million dollars to deposit into his Capital First Bank account, bringing his total account to 9 million dollars.
Capital First has now “created” 8 million dollars of credit and effectively injected this “new money” into the economy of the United States of Everywhere.
All this was made possible by two things:
-Bob trusted that the Chairman of Capital First Bank would keep his money safe and that is will be available to him whenever he needs it.
-The Chairman of Capital First Bank trusts that the entrepreneurs that he agreed to loan, in total, 8 million dollars to, will do a great job and that their hotels will attract many tourists to the pristine coastline of the United States of Everywhere and that they will make enough profits to pay back their loans.
2. Things are expected to get better in the future
-The business plans of the entrepreneurs all expect enough profits to pay back the loans, otherwise the Chairman of Capital First Bank would not have loaned them the money. These business plans expect that the tourism environment will be positive or continue to be positive.
-If this wasn’t the case, then it would be evident that the entrepreneurs wouldn’t be able to pay back their loans and Capital First Bank would go bankrupt.
From an initial 1 million dollar deposit into Capital First Bank, 9 million dollars was finally created, in our example, through credit. We can reasonably expect that all of Bob’s building would produce even more happy sub-contractors and they would in turn deposit their new dollars into the Capital First Bank accounts, enabling the Chairman to make new loans.
Essentially the economy of the United States of Everywhere has been given a solid and impressive boost thanks to the new bank and the use of credit. And everything works well thanks to the trust in the system.
And the trust is important. Imagine if Bob overheard one day that the Chairman of Capital First Bank was embezzling his money. He would go straight to the bank and demand they give him all his money. Of course, Capital First Bank only has the initial deposit of 1 million dollars and would never be able to honor Bob’s request.
Capital First would need to request immediate payment from each of the entrepreneurs to honor Bob’s deposit and given that the hotels are not yet open or not yet making money, the entrepreneurs wouldn’t be able to pay. As the assets are not yet “proven”, they would probably not be able to sell them at their cost to build and would be ruined. This situation would lead to the quick demise of Capital First Bank and bring the entire United States of Everywhere’s economy to ruin.
These are the exact same premises on which our modern economy is built. 97% of the money in circulation today is created by banks using this credit mechanism. Banks in the United States of America currently lend at an average of 9.77 times their Tier 1 capital. This is known as their “leverage ratio”.
Coming bank to our example, if we imagine that more and more entrepreneurs start believing in the attractivity of the United States of Everywhere’s pristine coastline, they may all start trying to build hotels or annex services around tourism.
Over time this would start pushing up the prices of hotels and these annex services as demand for these assets grow, and the original hotel owners might start selling and making hefty profits. Imagine if the press then started to talk about this new “Eldorado” of hotel owners and tourism players, and if more and more people started clambering into the sector. Very soon, we could see a “bubble” in this new tourism sector.
But then what would happen if the initial tourist numbers started declining as the pristine coastline started getting spoilt by all the new, out of control, building?
Suddenly a wave of panic could start sweeping through the industry as tourist arrivals declined. Jumpy investors could start selling their assets, hoping to get out their money while the going was still good. Some might drop prices to ensure they sell their assets quickly. Very soon, prices could start tumbling and a large numbers of investors could be ruined.
The bubble could burst.
What is a bubble?
In 1717 France, John Law created the Compagnie d’Occident (“Company of the West”) and obtained exclusive privileges to develop the French territories in the Mississippi River valley. On paper the venture seemed too good to be true. In reality, swamp lands were not a great place to be building a venture on.
Given the potential for profits involved, public demand for shares in the Compagnie increased sharply, the price for a share going up over 36 times. This was of course mainly based on hype and was completely out of all proportion to earnings.
The expected profits from the Compangie were slow to materialize, and the general public and investors lost trust in John Law and the project. Everything ended in complete disaster in 1720, when the value of the shares plummeted to zero.
Financial Bubbles are now fairly commonplace and we could talk of the Tulip bubble in 17th century Holland or the Sub Prime Debt bubble in 2008 or even the recent rise and fall of Bitcoin. Some bubbles like the Compagnie d’Occident or the Sub Prime can take down entire economies, while others can just ruin naïve investors.
Canadian economist, Jean-Paul Rodrigue sums up the four stages of a Bubble well:
- The Stealth Phase. This is where a new market opportunity is recognized by early investors.
- The Awareness Phase. Prices begin to rise attracting more and more investors. The price is supported by media interest, which ass to the upward momentum. Less knowledgeable investors start being attracted to the investment.
- The Mania Phase. Everyone starts seeing the price increases. Think of the media saying things like “a new paradigm”, “the investment of a lifetime” and the like. Prices no longer reflect economic reality or the underlying asset or income stream. Prices spiral out of control. Sometimes knowledgeable investors start getting back into the investment class, hoping to make money off the less knowledgeable investors. Reputable investment media could even start creating indices and exclusive content about the investment.
- The Blow-off Phase. Eventually market participants realize all is not as it appears. Buyers dry up and prices fall quickly. A crash ensues.
Go back and look at the recent Bitcoin example. Do you recognize the various stages of a bubble?
What should you do to protect yourself against a bubble?
1. Make sure you don’t put all your eggs in one basket
Diversifying your investment holdings is the best fail-safe against any bubble. Making sure you are never over reliant on one asset class is key. If, for example, you allocate 5 percent of your assets to one asset class or stock, even if that asset class or stock is worth zero tomorrow, your maximum loss is 5 percent. It’s simple and fool-proof. Yet so many people don’t do it.
2. Re-balance your portfolio on a regular basis
Read number 1 above again just to make sure you’ve understood it. When one of your investments takes off and your wealth starts concentrating in that asset: re-balance as soon as you can. You may lose out on some upside, but just think of what you will save if things come crashing down.
3. Recognize a speculative asset or one that has no grounding in reality
Make sure you’ve understood the explanation of how money is made and the basic fundamentals of trust and the belief that the future will be better.
These critical notions underpin our entire financial system, including stock markets. However fictive these notions are, they also still need to be grounded with real assets that have the potential to bring in future profits.
If you spot an investment that is not grounded with some real asset that can one day have the probability of making money, then steer clear of it, or go in with your eyes wide open.
What happens if it all comes crashing down?
You may be nearing the realization or possibly you already got there, that the notions of trust and believing things will get better, however powerful to date, might not endure and could be wondering what then happens?
Any crisis of trust or belief that things may actually get worse in the future would initially impact the banks through a “bank run”.
A bank run happens when a large number of people withdraw their deposits from a bank believing it might fail.
More recent history has afforded us a good example of what might happen.
Let’s look at 2008.
In March 2008 a bank run started at Bear Stearns. While not an ordinary bank, it had sold a considerable amount of asset backed commercial paper and was vulnerable to a bond holder run, which is exactly what happened. This was due to a failure of trust in the ability of Bear Stearns to finance its liabilities. But there was a larger weakening of the entire financial system, given the starting sub-prime crisis, triggered by the bursting of an asset bubble, that started in late 2007
Bear Stearns knew it could not meet its deposit obligations, as no bank can, and applied to the Federal Reserve for a loan, which was agreed.
As investors still had trust in the United States of America and the Federal Reserve, the contagion effects of the run did not go above the level of the banking industry.
In October 2008 a run on Icelandic bank Landsbanki occurred and again the government had to step in to take control of the bank. Again, this was partly successful as people trusted the government of Iceland. While this did put pressure on the small state of Iceland, luckily a large number of British people held deposits in Landsbanki and this soon became an issue for the British government. Thankfully more people, institutions and countries trusted the British government, and this helped eventually resolve the situation.
To date, our financial system has been preserved by the trust people have in the ultimate gatekeepers of the entire system that binds all our wealth and our ability to create wealth through credit: Governments.
So, we can rest assured that the fail-safe exists, is efficient and has proven, to date, that every crisis of trust can be quickly resolved, and the world of continual growth (or a better future) saved and put back on track.
Without the effective functioning of this fail-safe at a global level, which is unlikely, a significant crisis of trust could mean the effective end of our modern financial system and a return to the pre-modern era where credit was extremely scarce and growth virtually non-existent.
Until that unlikely event of a global meltdown, make sure you continue to diversify your holdings, not just in asset class but also in country-class and beware of anyone touting “the investment of a lifetime”.