How The Economy Works

Aug 2014

 

“Using money to motivate people can be a double-edged sword. For tasks that require cognitive ability, low to moderate performance-based incentives can help. But when the incentive level is very high, it can command too much attention and thereby distract the person’s mind with thoughts about the reward. This can create stress and ultimately reduce the level of performance.”

– Dan Ariely, The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home

 

“When you are deeply passionate about what you can be the best at and what drives you, not only does your work move toward greatness, but so does your life. For, in the end, it is impossible to have a great life unless it is a meaningful life. And it is very difficult to have a meaningful life without meaningful work.

Perhaps, then, you might gain that rare tranquility that comes from knowing that you’ve had a hand in creating something of intrinsic excellence that makes a contribution. Indeed, you might even gain that deepest of all satisfactions: knowing that your short time here on this earth has been well spent, and that it mattered.”

– Jim Collins, Good to Great: Why Some Companies Make the Leap…and Others Don’t

 

A big revelation I had once was understanding how universities make money. About 40% of it comes from student fees. 20% comes from licensing, commercialising research and donations. And about 40% comes from investment returns on their endowments. The third one is what surprised me.

An endowment in the sense of a university is a big pool of capital made up of the profit generated by a university. It is the remainder of university fees and income, after the cost of running the university is paid for, mixed with donations from the government, wealthy people and ex-students. They can get very large. Harvard for example manages a 30 billion dollar endowment.

What this means is that a big university will put their endowment money into a big fund. That fund will be dispersed into lots of smaller funds run by investment managers which will be invested in different areas. For example a hedge fund which invests in the stock market, a venture capital fund which invests in small private companies and makes them big or a private equity fund which invests in big private companies and grows them bigger.

These companies can do anything. Some might be big ones that build buildings and houses and infrastructure like telecommunications and energy. Others might be small ones that create software or retail stores. Others might be companies that create art or run deep sea exploration. Still others might be research driven trying to create new technology or inventions. The point is that what the company does largely doesn’t matter for our example.

There are other types such as funds that focus on distressed debt – lending, buying and selling companies that have financial problems; emerging markets — countries whose economies are not yet mature; currencies – buying and selling foreign currencies; commodities – buying and selling minerals or food on a commodities exchange; mezzanine – lending money to companies at a really high interest rate with the ability to convert into equity in the company if not repaid. But hedge, private equity and venture capital are the famous ones. Each of these vehicles charge fees to manage the money and to invest it.

They will put the money into a fund. The fund will make investments. A few years later, it will sell of the investments, return the money to the endowment, keep a bit for themselves as a fee, and the university which started with X amount of money will now have a multiple of it, maybe 3X. It will then do this again ad infinitum. This accounts for a major source of income for big universities. Almost as much as providing education for students.

 

It turns out a lot of big institutions with big capital reserves do this. Big companies, big charities, superannuation and pension funds, banks, governments, insurance companies – they all have huge amounts of money sitting around doing nothing. And so they do the same thing. Sometime in the mid 1900s it was discovered that this vestige of underutilised capital could be invested en masse and multiples could be returned. Effectively using a huge amount of money to make another huge amount of money. Using capital to make money as they say.

Capital and money basically mean the same thing. It’s just a fancy word that has less evil connotations. Say the word money and a small part of you starts to feel sick. That feeling doesn’t happen when you say the word capital. They are used interchangeability though it is common for finance people to use capital for referring to a large amount of money. You wouldn’t really say having $20 dollars is having capital even though this is entirely accurate. Frequently people say money when it has been earned but capital when it is yet to be spent or deployed.

This is also how a lot of charities make money. I’d bet most people think when they’re donating to a charity it is going directly to people in need. But usually there is a delay of a few years as the money is put into a fund, invested and returns on it are generated. By the time it gets to the people in need, it has actually doubled or tripled in size. So charity recipients benefit even more because of this big abstraction in the middle that is investment funds and institutional finance.

It’s also how lots of banks make money. And the government with the taxes they collect. Lots of people think their taxes go directly to the government who spend it. But usually there is this investment fund in between whose purpose is to amplify it. When people put their money in savings in a bank, the bank uses it to make investments too and then returns it to the person. I always thought that was really clever. The bank invests my money. Delivers a return on it. And then gives it back without me noticing.

The system is designed so there is never large pools of unused capital. Capital is always used to beget more capital. Theoretically, it’s supposed to be channelled to where it is most needed, in the best interest of society. The people who manage all of this money are professional money makers. Their sole job is to use money to make more money and not to lose what they have. They get paid a fee for this.

It’s kind of a beautiful system. Especially when regulated because it means unused money can be used to make more money which helps more people. The regulation ensures that under no circumstances can the investment funds lose the funds they manage. It doesn’t matter what the upside may be, the downside is they are not allowed to lose.

So it also can be a powerful force for good. The government can mandate it be channelled into areas with the most need. Things like universal healthcare or a welfare safety net or necessary infrastructure like like faster internet or roads and building or new forms of renewable energy. Things that are good for society. And they have to follow that. Instead of being spent directly, the capital goes into companies creating these things.

One of the worst things ever to happen was the deregulation of finance. Because it commodotised the business of finance and meant people could choose to be greedy and serve themselves instead of the good of everyone. And so a lot of people get rich betting on things that leave people worse off. Such as Wall Street firms who become rich from causing starvation. Benevolent finance can do a lot of good. But the opposite can do a lot of bad.

They started to take bigger and bolder risks which, if they payed off could make a lot more money. But if they didn’t, could actually lose capital. This is what happened during the recession. Large investment funds had stored their money into assets which lost value. And so it was common for funds to lose all of their money in one swipe.

The funds balance this risk by having a portfolio. So they invest in a lot of different things which reduces the effect of any one failing. When not regulated you get situations where greedy managers could take big risks and potentially lose the capital they are managing. Which means they’ve lost the money of charities and peoples retirement savings and university endowments and pensions. This is a very bad situation.

 

You’ll notice all of these funds have something to do with companies. They’re tied to each other in the same way two co-dependent organisms are. Neither can really exist without the other. If one starts to suffer, so too will the other. Likewise if one starts to thrive, so too will the other.

Companies need capital to grow and capital needs companies to invest in. These two things working in harmony are vehicles of growth for an economy and how new technologies are created. A flourishing economy and better technology is good for everyone.

In a lot of ways it would be inordinately difficult for an entrepreneur to succeed without raising capital, whether that’s from a bank or from investors. The number of big successful companies that have succeeded without doing so is near 0. Likewise the investment funds have to invest in winning companies. If they don’t, they’ll quickly cease to exist.

So all of these different funds fight with each other to get the best deals and to generate the best returns. That competition channels money into the places they’re needed and where the most amount of growth can be realised. Theoretically, the areas where the most growth can be achieved “are” where it’s most needed. Finding these pockets is supposed to be the job of money managers.

The cycle of how it all works is the interesting part. Because it all seems hidden but is in plain sight. It is the primary method of how value is created. It’s all around us but few see it in action. We can see it with the university example by charting the flow of capital around a hypothetical student:

A student wants to go to university. So they pay fees to get a degree which will help with their future job prospects. Those fees are used to run the university and the remainder is put into an endowment which is put into an investment fund.

The investment fund puts money into a venture capital fund. That VC fund invests in a small company started by an entrepreneur and grows it into a big one, creating lots of new jobs. This company hires people and hires that same student when they graduate. The student now works for the company and earns a salary.

They use their salary to buy things providing a high quality of life for them, but also provides customers for businesses. When people are buying things, companies thrive. The university investment fund also puts money into a private equity fund. They invest in that same company and make it grow larger then take it public onto the stock market. Our student has been working for years, the company is doing well and they get a promotion and earn a bigger salary. They use this to buy a house and start buying shares in the stock market to get more income.

They also start contributing to their superannuation and pension. Additionally, any savings they have are put into a bank. These savings are used by the bank to make investments. All of this money is put into another investment fund which this time is put into a hedge fund. This hedge fund invests in a public company that has discovered a way of curing a life threatening disease but needs capital to make it a reality. It also invests in a company that builds infrastructure and apartment buildings. One of which our student ends up buying and moving into.

When that student gets older he develops a life threatening disease and pays our above company to cure it. When previously he would have died, he now survives. The company does well, the pension money is returned and when our student retires, he receives his pension. He then sends his kids to university. The university is now a better one because they used the investment income to improve their degree programs.

Our student hasn’t seen any of this take effect. But they were instrumental to the existence of all of these companies. This is a simplified example but this same process averaged over a population of millions of people is how the economy works. It’s how jobs are created, how the quality of life improves and how new technology is brought to the market. And it’s fueled by entrepreneurs and large pools of capital.

 

It’s why a lot of the hatred towards finance is misplaced. What they are really against is greed. Inherently it is a good thing but in this is the ability for a lot of destruction to be caused by singular individuals. If a hedge fund tries a risky strategy and loses all their money, the people who really lose are the ones who provided it like the charities, universities and pensions.

If companies and finance were an ecosystem, the habitat that a lot of this plays out in is the stock market. Most big companies have at some point taken outside capital. Some have succeeded without it. But they are the minority and if it does, it takes longer.

Capital can’t be put into a private company without an avenue for it to come out. That avenue is usually the stock market. What it does it create liquidity, which is essentially how easy it is to buy and sell something. If something is easy to buy and sell then there is liquidity. Something difficult to buy and sell is illiquid.

The proxy for how people observe and measure all of this taking place is economics. It is like studying thousands of micro-decisions that have an impact on a broader environment. Where this all takes place is called a market. The two big economic ideas are by John Keynes and Friedrich Hayek.

The first believes this is an ecosystem that should be controlled and is how you get a lot of government intervention in the market. The second believes that, like the environment, it should be left alone and will correct itself.

In a natural selection sense, the strong companies will thrive and the weak will die out and intervening is a perversion of the core of how it works. Because it stops the weak from dying. And if they can’t die, then there is no downside from doing disagreeable or destructive things. It removes the stick so there is only carrot.

Both are probably right and you see elements of both taking place constantly over the course of human history. Their ideas have shaped how every major government treats and looks at their economy. Without understanding something you can’t hope to influence it.

 

In this ecosystem there are typically people you might consider good guys and bad guys. Most probably wouldn’t even realise they are the bad guys. You start to see cracks in the system when for example, big companies with large pools of capital start putting it in endowments instead of spending on research and development to create new products. That’s bad.

That’s how you get bad macroeconomic indicators. Like when big car companies receive fuel subsidies from the government instead of innovating away from fossil fuels even though it is well documented how devastating this is for the environment.

Or when companies have large pools of capital but unemployment is high. Because they have money but aren’t hiring people. They’re signs that something else is happening and the government should intervene. Because it means capital is flowing into fewer and fewer hands.

It’s a necessary balance. Having a thriving middle class is one of the keys to a healthy economy. Lots of people earning money. Because they’re also the ones who spend money buying the products made by companies. When companies aren’t hiring, this doesn’t happen.

Aggregate dollars in the hands of the middle class drops. And for big companies, it’s shooting themselves in the foot because they are reducing their pool of customers. Eventually there will be fewer and fewer people who can even afford to buy their products so they’ll have to stop making them.

It’s why an investment in creating a flourishing middle class is always a good one. And is why this process on the whole is beneficial. Because it is a primary driver of creating a middle class. Things like investing in infrastructure, education, healthcare.

Because the more wealthy the average person is. The more they earn and the more they can spend. Because most of that money goes to companies when they buy their products. It increases the broader pool of customers and revenue earned for companies. Companies earn more money as a result of paying people more.

A common argument against this is that when lots of people earn more money, the cost of living goes up as the value of a currency goes down because more people have it. But that happens anyway. The cost of living always goes up. But the money that average people have or earn typically doesn’t without some kind of government intervention forcing it to.

It’s why having a government mandated high and increasing minimum wage is such a good thing. It’s a beautiful thing because it both protects the average person from being exploited and allows them to participate in the broader wealth creation which they contribute to.

As society becomes wealthier, they too become wealthier. Places that don’t have a high minimum wage have the opposite. Society becomes wealthier but the average persons net wealth goes in reverse. It doesn’t keep up and very quickly they get left behind.

The counter argument is that if a minimum wage goes up, unemployment goes up too. This is a simplistic way of thinking. It is literally – as the cost of labour increases, people will hire less people because it’s more expensive to. It’s what a lot of politicians say when they try to protect the interests of big business. On the surface it seems right but is false and provably wrong. Countries with high minimum wages tend to flourish not go into decline.

It’s a dangerous line of reasoning to consider an argument that advocates in favour of taking money away from average people in the name of creating more jobs. It doesn’t actually fix the economy, it hurts it further. This becomes a very slippery slope and can accidentally create a lot of suffering and harm a lot of people.

 

The people who manage all of these pools of capital have a great influence on the future because where they channel it decides what gets created. Similarly the people who start great companies and are the recipients of capital have a great influence because they are the ones creating. They go hand in hand.

Most of the way this all works is behind the scenes and people don’t realise. It’s difficult conceptually to see such vast amounts of money moving around and not start to feel a bit sick. Capital is like the blood of the economy and this process is like the veins that send it where it’s needed. Every country has their variation of this. But to summarise the process in a paragraph. In the abstraction, is as follows.

A company starts. It raises money from banks or investors. Investors get their money from bigger funds. The bigger funds get their money from countless individuals donating to charity, saving money in a bank, going to college or saving for their pension. The company grows and makes new things. As it grows it hires people and creates jobs and business.

People work for these companies. Those people buy things. They buy the products produced by other companies. As they earn more, they spend and save more which improves their quality of life. They donate to charity, save money in a bank, go to college, get taxed and save for their pension. This eventually gets pooled in one of the bigger funds. Which places it into smaller funds. The smaller funds invest in companies starting.

It’s an endless cycle that is attributable to the progression and sophistication of the human race. It’s how we get better and make new things.

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