Video Transcript: The Place of Finance and Financial Markets in a Free Society

My lecture here, I want to give you a little 45 minute talk on the place and the  role of finance and financial markets in a free society, and it's in the sequencing  of classes. It's very apt that it comes right after Professor Herbiners Talk on  fractional reserve banking, because in the last lecture that you listened to, he  talked about some of the problems, the, you know, the why we have fractional  reserve banking, where it came from. But really, what are the problems that it,  that it creates? And you know, the problems, they're really not unknown. All  economists understand these problems. I mean, Lucas, do you teach intro, econ or intermediate macro? I mean, it's pretty standard in the textbook that you talk  about the problems of fractional reserve banking, but then, you know, you kind  of brush them aside and, well, that's the, that's the banking system we have,  and it's better than nothing. So that's kind of it. And that all said we have this  fractional reserve banking system. And for us, when you personally need  financing, probably the first place you go to is mom and dad. But then after mom and dad, if you're like me. And then after, you know, after your parents cut you  off, finally, then you go to the bank. So you want to finance your education, go to the bank, take out a loan. You want to buy a car, go get a consumer loan. Go  you want to buy a house, fantastic. That's, that's what banks are there for, right?  You go and borrow from the bank. And the same time, if you have savings, if you want to make an investment, oftentimes, you go to your bank to make  investments. I mean, you have, you have some savings, you're in the bank  anyway, sure, I'll buy a savings product. And it's very strange, because the bank  is the first place we go to for most of our savings and investing decisions are  investing and and lending decisions rather. But Professor Herbener just said,  Well, you know, fractional reserve banks, there's a lot of very difficult, thorny  issues with them, and they don't function all that well, or as well as you'd think.  So. I want to give you kind of the alternative of where financing would take place and how it would take place in a free society, one without fractional reserve  banks. So to just get a little bit of brief terminology out of the way, finance, if you  want to give it a concise to such definition, it's just the study of investments, but  included in investments are many sub topics that are very important, and some  of them you haven't gotten to yet. In the sequencing of classes, the time value of money, if you've taken an intro finance or economics class, this will oftentimes  come up just the idea that, what's the expression a bird in the hand is worth two  in the bush? Is that how it goes? You'd prefer to have things now rather than  wait into the future for them. I'm not going to get into that right now, because  Professor Herbener Tomorrow will give a lecture devoted to time preference,  interest rates and really the time value of money. But just suffice to accept right  now that we would prefer to have money now versus the same amount of  money in the future. The concepts of risk and uncertainty are inherent in  investment decisions, because you're buying an asset today in order to get a  sum of money in the future, so you don't know how much you're going to get or 

whether it will pay out, or anything like that. Legal regimes are oftentimes  important, like, for example, we'll say, Well, the big distinction between stocks  and bonds as investment vehicles has to do with the legal regimes that that  bond holders are secured creditors, and they're higher in the hierarchy of who's  going to get paid off if the if the asset goes bankrupt again. I'm not going to get  into it, but the topic of finance includes many subsidiary topics that will come up  throughout the remaining days of Mises University, and then financial markets  themselves, which are much more important for this lecture, are just the place  where lenders and borrowers meet together in order to strike deals that are  mutually beneficial, to make investments or to borrow from each other. And  these lenders and borrowers, if you're a lender, it would be somebody again,  these terms haven't been introduced, and they won't until tomorrow, but  somebody with low time preference is somebody who's willing to not consume  today but wait until the future. And somebody with high time preference is  somebody who lives in the here and now wants to spend money today and, you  know, is not willing to wait until the future. And really, the financial market is  where these people with different preferences can meet in the same way that  the t shirt market is where people with a high time high preference for T shirts  meet with stores who have a low preference for T shirts, they get together and  they strike deals. Financial markets are no different. It's just that the preferences are a little bit distinct. And the actual financial markets that we have are, you  know, the normal ones. Well, actually the normal ones you think of are probably  the capital markets, the stock and bond markets. Then you have money  markets, which are like short term lending some oftentimes through banks,  actually, but that's bad. I don't want to get into that. Futures markets, a little bit  more complex, or commodities markets, you know, buying, buying wheat, gold,  whatever have you on, on organized exchanges. So that's just as some a brief  intro on the type of markets we're looking at. But really what's important is the  preferences that people who are meeting in these financial markets actually  have. So here's our preference ranking, basically from yesterday. Person A  would most like to have a car today. Then he would like to have $10,000 in his  pocket. And if not that, he'd prefer to have $10,500 next year. And dot, dot, dot,  all the way down. Then he'd like to talk to Joe Salerno. And I shouldn't be so  hard on Joe, because I just. Didn't have room to extend the preference ranking  down. But Dave Howden isn't even he's like way down there the 100th  preference rank. So Joe's actually doing really well. And then Person B. Person  B is a little bit different, which is important, he would most prefer to have 10,500  one year from now. Then he'd like to have 10,000 today, then he'd like to have  9000 today. Dot. Dot, dot. All the way down to having a chat with David Gordon,  who's also not here, so I'm not even anywhere near this high on David Gordon's  preference ranking. And the important thing when you look at person A and  person B is that they have reverse preferences, because right here, person A 

would much rather have $10,000 today than 10,500 next year, which is the  exact opposite relationship to person B. And so you can imagine that there is  scope for a trade to be made where Person B, who has $10,000 trades it to  person A, and Person A trades back to person B a promise to pay back 10,500  next year, and then, of course, what's Person A gonna do with the $10,000 they  just got, buy the car, satisfy the most pressing want that they have? So we've  got a very we've got a disagreement of values, but the value that we disagree  with is the value of our time, or the value of the money over time for each  person, and the values are completely reversed in what they want, and from  these reverse valuations, we can also create the interest rate, or we can also  determine the interest rate for lending and borrowing money. So Person B, since they're going to lend A $10,000 today and then get back one year from now,  $10,500 that's the same thing as saying they're going to earn a $500 interest  rate. And 500 on 10,000 is 5% so they just invested in Person A, some kind of  an investment, let's say a loan at 5% and Person A is in the exact opposite  situation. They have to pay back that loan at 5% interest to person B. So we  have a very simple scenario that defines the lending borrowing relationship  between two people, and it stems ultimately from disagreements or conflicts on  the preference rank, where two people have have reverse preferences. Now,  one of the things that I always start with in class because, for some reason,  there is this, I don't even know what you call it, this psychological people are  psychologically predisposed to think that lenders are good people? No, maybe  that's not the case. That people who have have excess money, like they have  savings and they can lend it to others, they're good people, and people that are  in the position where they have to borrow their you know, deadbeats, or they're  bad people, or there's something bad about and wrong about having to borrow  money. But economics, because it's a value free science, we don't take these  positions. Like being a debtor isn't inherently good or bad. Maybe it could have  been a bad decision after the fact, but you never know that ahead of time, being  a debtor is just something that might be necessary given the person's situation,  like that person who preferred to borrow money now rather than save their  money, that person's not bad and they're not stupid or anything like that. That's  just their preferences. And at the same time, lenders are savers. They're not  inherently virtuous, like they're not great people, just because they're lenders or  savers, although, you know, that's something you should strive for personally, I  think. But it's not naturally virtuous or in the same way. You know, another way  to look at it is, a lot of mainstream economists think savings are terrible because that means you're not spending money, and if you're not spending money, or  you're not creating income for other people, other people. So they think that  you're a miser and you're somebody that's bad, but that's not true either. It's just  you have preferences for saving and borrowing, and it's neither good nor bad. It  just It just is. So I just wanted to get that out of the way before we start. Now, 

Professor Herbener gave this lecture on fractional reserve banking, and I  wanted to give you kind of an in depth look of how this financial contract works,  like how the lending actually works, and what it means for you. And before I  start, just out of curiosity, put your hand up. No, wait, I should ask the question.  Before I say that, who thinks that they are the owner of money that's deposited  in their bank, the legal owner. Put your hand up, Joe, you do, but I'm glad you  did. In fact, your bank is actually the legal loaner, according to the letter of the  law, your bank is the owner of money that you deposit in it, which is really  strange. I mean, I'm offended by it. I don't have a better word for it. I think it's  completely ridiculous. I worked hard for that money and I entrusted it with a  bank, and now they're the owner all of a sudden. And it's very strange, but it  flows naturally from this very strange legal framework that Fractional Reserve  Banks function within. So the base deposit contract, it's, it's a bit of a hybrid.  Well, it's not a bit of a hybrid. It's exactly a hybrid, because it combines two  fundamental financial contracts. You deposit your money in a bank, and we'll get into the details of what that means in a moment. And then your bank lends that  money out. That's the process Professor Herbener walked you through in the  previous lecture. And so to you, your money is a deposit, and to your bank, your  money is a loan. And so the whole fractional reserve demand deposit. That even though we call it a deposit, it's really this hybrid loan deposit, hybrid, you know,  very strange frankensteiny type of financial contract. It only exists in banking, by  the way, it doesn't exist in in any other line of business. So it's very unique to the financial system. And to understand why it's so strange, it's important to  disentangle the contract into its two component pieces, and since your bank  thinks they have a loan and you have a deposit, it's good to go back and just  revisit what's the difference between a loan and a deposit. And I want to walk  you through the three fundamental economic differences, and then I'll take you  through the resultant three legal differences. So on the economic side of things,  the first key difference that you see is that with loans, you're always exchanging  what we call present for future goods. Like in the preference ranking that I  showed you, originally the person who was the lender, they were getting rid of  their $1,000 today, but they were obtaining in return the promise that they would  make 10,500 in the future. So they gave away a present good, and in return,  they're getting a claim to a future good, but they don't actually have that future  good yet. So there's an inter temporal exchange taking place, but economically  speaking, in the deposit contract, we have no such exchange. You deposit your  money in a bank, and you can always access that money whenever you want. It  like you go to the cash point, you go to the teller, you ask for your money, you  get it on demand or in the present. So there's none of this inter temporal  exchange going on there or present for future good exchange going on. The  second key difference is that in a loan contract, you necessarily have to transfer  the availability of the good that you're lending. This is necessary for two 

reasons. On the one hand, the person who's borrowing, they're borrowing  because they want to use whatever it is that you're lending them money in this  example, so you can't retain availability of that otherwise, that person would not  be able to use it. Two people can't make use of the same resource at the same  time. But on deposit contracts, this is different, because the money is always  available to you, like your deposit in a bank is yours, and even if you're not using right now, you can use it. You can go to the cash point and request it. So the  availability always remains with the depositor. And then the final economic  difference is that, because there is a difference between Present and Future  goods on the preference scale, there has to be a resultant interest rate that  results from this exchange while with a deposit, since there is no exchange of a  present for a future good, there will be no interest rate. So we have very  significantly, economically speaking, a deposit could not have an interest rate on it, but a loan necessarily must have an interest rate on it. And these three  economic distinctions naturally give rise to three key legal distinctions between  the two contracts. And the first is, maybe the most important in my eyes, is that  the purposes of the two contracts are fundamentally different. So with loans, the  very purpose of you making that loan is to transfer the availability of a good like  somebody only borrows because they want their purpose is to get the  availability of that good so they can use it over the time period that you've  contracted for while with your deposit, you never have a purpose of sacrificing  your availability. You always want to keep it there available to you. I mean,  you're not being remunerated through an interest payment. We already saw  that, so the only reason you'd make a deposit is to keep the availability and use  it when you want to and instant. Interestingly enough, this difference in purpose  is important because if you go back, if anybody's taken a law class, or if  anybody's a lawyer in contract law, there's, there's several, several steps that  are necessary for contract formation, and one of them is what's called a meeting of the minds. You have to have a shared purpose. Like you can't go to  somebody and say, Hey, I'm going to sell you my boat and have that person say, Yeah, I'm going to borrow this boat from you. That's not a meeting of the minds,  because you have two different purposes to the contract. And in the same way,  since we have conflicting purposes here, you can't just go to somebody and say, hey, I want to lend you money and have that person say, Yeah, I'd like to deposit my money with you because you have these conflicting purposes. So it's very  important for contract law, for legal formation, that you have a shared purpose,  which notably doesn't exist in the fractional reserve deposit contract. The  second key legal difference is that in a loan, you have to have a term, both a  minimum and a maximum. The reason for the minimum is that the person who's  borrowing needs to be secured, be secure in knowing that they will have that  borrowed good available to them, for them to use for whatever they want for  some minimum amount of time, like use something simple, like, I've got a copy 

of George Reisman's capitalism. Anybody read that? Be honest, really? Lucas  George Reisman's capitalism. It's down the bookstore. It's, I don't know that  thick. It's, I don't know how many 1000s of pages it's, you know, it's a huge  book. So if I lent my copy to you, you would need a minimum term on this,  otherwise it would be useless for you to borrow it from me. I mean, I don't know  what two days, maybe at a minimum. Just for you to peruse the preface of this  book, something like that, or go through the index or see the topics, or  something like that. So we have a minimum term that needs to be established  and at the same time. And maybe more importantly, in your mind, you need a  maximum term. Because if I gave you my copy of capitalism and then I said,  Yeah, but don't worry about giving it back to me, I wouldn't be lending it to you.  I'd be gifting it to you. So a loan needs to have a maximum term with which I  know that I'm going to get it back. And in financial contracts, these are typically  explicitly stated. I mean, we have written contracts that spell it all out for us  between friends. Typically, you don't have to, but they're implicitly there. You  give somebody something to your friends, and you know you're going to get it  back after. You reasonably think you'll get it back after a week, a month,  however long. Well, with deposits, there's no term necessary. You put your  money on deposit in the bank, and you don't have to ask for it back, and the  bank doesn't have to say, No, you can't have it back. And as long as you keep  paying your fees, your service fees, there is no loan, sorry, there is no term  established with the deposit contract. And then the final legal difference is in the  obligations. So the obligation for the person who borrowed money from you, if  it's a loan, is to return whatever that good was that was borrowed money, your  car, my copy of capitalism, whatever have you. Well, with the deposit, the  obligation for the depository, like a bank, is just to keep the goods safe and then  return it to you whenever it is that you ask for it. And since there's no maturity,  since there's no term on your deposit, you can ask for it at a moment's notice,  right? You just go to the cash point, put in your card, get your money, or go to  the teller, or whatever have you. So we have three key legal differences  between these two types of contracts. Now these three key legal differences are really fundamentally, what the problem, at least the legal problem with fractional  reserve banking is, because, of course, your bank, all of these things are should be true for your bank, but of course, also none of them are true for your bank  because they don't really abide by the strict details of the legal contracts. And at  the same time, these should be true for you, but they're not necessarily true at  the same time. So we've got this very strange legal creation in the fractional  reserve banking contract. But that notwithstanding, that seems to be where an  awful lot of the lending activity, at least for consumers and small businesses,  takes place in the economy. It's loans that are based upon your deposits going  off to some third party. So instead of that, I want to give you a glimpse at what  you would be doing, or how you would be securing financing or making 

investments if you didn't rely on your fractional reserve bank. Because a  common criticism that I hear people ask Austrians, well, if there's no fractional  reserve banking, how am I going to get a mortgage? Because my mortgage  right now is with my bank, and how am I going to get my car loan? And you  know, I'll never go to university because nobody will lend me money except for  my bank or the government. And you know, if we don't have the banking system, who's going to be making all those loans? And it's a good criticism, because you need an alternative, or you should have an alternative for people. So the way  that I want to start is by just taking a very bird's eye view at your income, your  earned income, and what you can do with it. And in general, we can say there's  three different choices that you can do with your income when you earn it. The  first thing is that you earn income and you put it in your cash balance, your bank account, currency in your pocket, whatever have you. And we'll get into the  reasons in a little bit for why it is that you would add to your cash balance, why  you would hold your income in the form of money. But for now, just accept that  you hold it because you're uncertain about something in the future, maybe an  expense is going to pop up, and so you want to keep a little bit of cash in your  pocket to face that uncertain event, uncertain event or expense. I'll give you a  more rigorous proof here in a couple minutes. Second thing you can do with  your money not pay taxes, but that's probably also also important consumption.  Well, you know, you pay your taxes in here with consumption expenditures, so  you can consume, right? You get your income, and you go and you pay money  for your rent, and you buy some clothes, and you buy some food and some, you know, all of those types of things. And really, what you're buying is what we  could call present want satisfaction. You are exchanging your money to satisfy  yourself with something in the present, like, oh, lunch was great. Now I'm  happier, fantastic. And if you're not satisfying yourself in the present, you're  satisfying yourself in the future. And that's really what your savings are devoted  to. You save money because you're willing to forego satisfactions in the present, but instead delay them for hopefully, an increased satisfaction at some point in  time, in the future, so you save your money. And the vehicle through which you  save your money, it's not just blind savings, it's in some investment product, and  you're saving up for something like you're willing to not consume all of your  income today so that you can have a better retirement 40 years from now, or  you're willing to not consume all your income today so that you can save up and  go for that vacation, over Christmas break, or something like that. So we have  these three paths that our income can be devoted to, and money is the big one.  So we need to establish or money for our purposes is is the big one. So we  need to establish why it is that you would hold money. Where does the demand  come from? Because we already looked at in my previous lecture on uh. Uh,  preference and subjective value and preference and price determination, where  your demands for the other goods come from. I mean, T shirts are on your value

scales, and what else is on your value scale, food in a car and all those types of  things. But where would money fit into this? Why would you actually want to  hold on to money and Mises in human action? He's got these great couple of  pages where he introduces what he calls the evenly rotating economy, to show a situation where money would not exist, so that you can pull the corollary out of it understand why money would exist and why people would want to hold on to it.  And it's a little bit strange when you're reading through it, because the Austrians, you know, in mainstream economics, they focus very much on equilibrium.  States and Austrians, rightfully so. Were very critical about this, because  equilibrium is not all that interesting in the grand scheme of it. And Mises  actually introduce introduces this evenly rotating economy, which is his  equilibrium construct, in a way. But it's actually useful, because it shows us all of these very realistic conclusions that we can drive from it. So the evenly rotating  economy is like this. There is a succession of temporal periods, years, weeks,  whatever have you, but nothing ever changes with the passage of time. Prices  always remain the same, day in and day out. Preferences always remain the  same. All of your buying behavior is always the same. Everything is always  constant. It's just time goes by, and that's that it would be like saying I wake up  every morning and I get a Egg McMuffin for breakfast, and then I go to bed that  night, and then I wake up the next morning and I buy an Egg McMuffin, and so  on and so forth until infinity. And when Mises teases out the consequences of  this evenly rotating economy. There's really three big ones. So the first one, he  says, is, well, there's no entrepreneurship. Since there's no change like, you  have no scope for an entrepreneurial function if there is no change taking place  in the economy. For example, McDonald's wouldn't have to work too hard to  notice that I wake up and I eat a McMuffin every single morning. That would not  be especially entrepreneurial of them to act on that if I'm doing it every day  without fail. More importantly, though, Mises says, well, there's no profits in this  evenly rotating economy, because the input factors, like the things, the higher  order goods that create a McMuffin would just be bid up to the final value, the  final selling price of the McMuffin. So we've got a bun. Let's say a bun costs a  euro and an egg. Sorry, a bun costs $1 and an egg costs $1 and a McMuffin  goes for $2 and that's that's basically it. And Mises says, Well, of course, smart  entrepreneurs would just bid up the price of egg and bun to whatever the final  selling price is. So there would be no profits, except there would be a value  spread between the value of those inputs, the egg and the bun and the final  selling price, which he attributes to originary interest. And Professor Herbner will give you tomorrow a much longer expose of this originary interest, but right now, I'll just make a few sundry and brief comments on it, because we need to be  remunerated for the fact that we're not consuming now versus in the future, the  value of the goods in the present will be discounted or lower than the good that  they produce in the future. So let's say, in this example, if I buy a McMuffin for $2

at the end of every day, and McDonald's creates it at the beginning every day,  they would pay maybe 90 cents for the egg and 90 cents for the bun. They  would buy those at a discount of 10 cents each. And then 10 cents would be  their remuneration for not consuming those things right away and waiting and  selling it to me in the in the afternoon or the evening. So the 10 cents would not  be profit for them. That would just be a remuneration for them to wait and not  consume the input factors or put them to use in the present. But more  importantly, when Mises looks at the evenly rotating economy, he says, There's  something very strange going on, that there's no money. Nobody wants to hold  on to any money. There's money prices. We know what. Everything is worth. $2  for a McMuffin. But nobody's actually holding on to money. And he has to  explain why this is and he says, Well, why would anybody hold on to money if  they were fully certain about what everybody all of their expenses were going to  cost in the future, like if you were certain about every single expenditure that  was going to arise in your life, you would never hold on to money and earn zero  interest. You would park your money in an investment that matures at the exact  moment when the expense arises, and then you would use the proceeds of that  investment to fund the expense. Example, let's say that. Let's say that I get paid  on the first of the month, and my rent comes due on the last of the month. I  would not just hold all of my income in the form of money. I could buy a 30 day  investment product that would pay some interest rate, not much right now, I  guess, but some interest rate, and it's going to mature at that exact moment of  time when my rent comes due. So of course, I wouldn't hold money. I would  invest it for the relevant maturity, 30 days, I would earn some investment income off it, and the money would still be available for me to pay my rent. Or  alternatively, you could flip the example around, and if my income comes. On  the first of the month, my rents not due until the end. I could go to my landlord  and I could say, I'll pay you a month early at a discount, like, Surely it would be  valuable to you to be paid earlier rather than later. So instead of, I don't know,  $1,000 at the end of the month, I'll give you $975 right now. So I'll be able to  settle up my expenses if I know they're going to happen at a discount. Or you  could go to your landlord, if you've ever tried this, if you rent a place instead of  paying rent monthly, just go to them and say, hey, I'll front end load all of my  rental payments, so I'll give you a whole year's rent right now. What? What kind  of discount will you give me? And surely they'll give you something for the  security and also the benefit of having the rental income come in sooner rather  than later. So Mises says, if you were fully certain about all of your expenditures, as you are in the evenly rotating economy, you would never hold on to money,  because you would buy a financial product to invest or settle up early at a  discount. So then he turns that example on his head, and he says, well, then it  must be that the only reason you hold money is if you're uncertain about these  future expenditures, and fundamentally, that's where your demand to come from

money. That's where your demand to hold money comes from, this felt  uncertainty, or this perceived uncertainty of what's going to happen in the future. But then he goes on to say, and make a distinction, that it can only be that you  are hedging yourself against uncertain events, things that you don't actually  know or can't probabilistically determine in advance. But you're not holding  money against risky events, because risky events you could theoretically invest  or settle up at a discount according to some probability. And he makes this big  follow on distinction between risk and uncertainty, which is relevant here? He  says uncertainty is a situation where you either don't know the outcomes of a  choice or you cannot assign probabilities to an outcome happening. He gives a  couple examples in human action. For example, I don't know, I forget if this is  the actual belligerence, but Germany and France go off and fight a war, who's  going to win? We can't really assign a probability statement to that. I mean, we  know the outcome is either Germany wins or France wins, or actually, in war,  both lose. But in the example, Germany wins or France wins, but we don't know  which side is going to win, and we can't assign probabilities. We could guess,  but we have no idea or sports games, which teams going to win. Well, I know it's either going to be one or the other, but I really don't know. At the end of the day,  there's betting markets, you might say. So they're probabilities assigned, but  they're not probabilities in any meaningful sense. They're just estimates. They're just guesses, and they're the estimates of 1000s of people getting together, but  they're not what we're talking about by by probability, quantitative probabilities.  And let me just contrast this with risky outcomes. Risky would be where you  know the actual outcomes, and you can make statements quantitatively about  the probabilities, like you roll a die and there's a 1/6 chance that each one of the  numbers is going to come heads up, or you flip a coin and it's either going to be  heads or tails. And you know 5050, shot of either or so we have uncertain  events and risky events. And Mises says when you hold money, it has to be for  these uncertain events. Those are really what you're protecting yourself against  or hedging yourself against through your money holdings. Now then, if that is so, what are the specific uncertainties that you're facing with respect to your money  holdings, and there's two unknowns with your future expenditures. You either  don't know when they're going to happen, or you don't know how much they're  going to be for. Like, something could happen. What would be a good example  of something happening, but you don't know when it's going to happen. Okay?  Yeah. Now be an optimist. Yeah, I know how you mean crash, probably,  probably you will get hungry, but you don't know when you'll get hungry, but you  are going to get hungry. There's no question about it, fantastic. Or alternatively,  you don't know when it's going to happen, but you know the magnitude of it. For  example, I'm going to keep rolling this dice. Maybe that's a bad example, but I'm going to keep rolling a dice, and when a one comes up, I'm going to give you  $10 but you don't know when exactly a one is going to come up, but you know 

when it finally does come up, I'll give you 10 bucks. So you have uncertainty  about timing, or how much, the magnitude of an expenditure, or with money  holdings. You're concerned about both of those things together, you don't know  how much or when the actual expenditure will be for, and that's why you're  holding money today, like the cash in your pocket right now, or the money in  your Deposit Account is held to guard against these two uncertainties that you  have. Now, let's bring it back to financial assets for talk on finance all financial  assets, to the extent that they involve exchanges of money, concern themselves  with two questions, what are you going to get from a financial asset, and when  are you going to get it? And with each of those questions, there's two responses  to each of them that we can get, which is where this typology is. Going to come  from what you get is really asking the question of, what type of value does a  financial asset give to you or allow you to have? And the two types of value that  can exist are what we call either par or market. Market is the easier to  understand. Market value is a value which changes as per the visitudes of the  market. We have supply changes, demand changes, and the price changes as a result. Like your car was worth something when you bought it, and then you  rolled it off the lot, and you lost a third of its value, and then you got in a car  crash, and that was the other two thirds of the value. And the value changed  according to the actual market conditions at the time. And par value is where the value is fixed or predetermined. A good example of this is money like, for  example, I don't actually have any good thing. Lunch was provided because I  don't have anything except for 25, 35 cents. This coin is worth 25 cents, which,  when I was a kid, used to get me lunch. But this 25 cent coin, no matter when I  spend it, the prices might change, but it's always worth 25 cents. I mean, the  face value is 25 so okay, maybe today I go and I buy a pack of gum, and the  pack of gum cost me 10 cents, so I paid with this 25 cents, and tomorrow,  maybe the pack of gum is gonna cost 15 cents, and I still pay with this 25 cent  coin. The value is always fixed, or it's what we call a par value. It doesn't change as per market conditions, and the question of when you actually get that  payment from the financial asset, obviously enough can either be right now in  the present, on demand, or at some time in the future after you wait for the value to mature or come to you. And with those two criteria, you end up with four  quadrants here. And each of the four quadrants outlines a specific financial  asset. So up in the northwest, I've already got it labeled, but money is the  unique financial asset to take that quadrant, because money is the only good in  the financial economy that sells in the present. Like the value is there at a  moment's notice, I use this and the value is released. I don't have to wait for it at all. And your Deposit Account is the exact same way, by the way, you get to use  it at a moment's notice, you swipe your debit card, you go to the ATM, whatever  have you, the value is available in the present, on demand, and you know how  much it's going to be for. Again, prices can change, but the actual value stated 

on the money unit does not change. So money is a very unique quadrant here.  And let's go up to quadrant two in the Northeast. Anybody think of an example of a financial asset where you get the value right now, but you don't know exactly  how much value you're going to get. It just depends on market conditions,  supply, demand conditions, stocks, right? You can sell your stock at a moment's  notice, always, what are you going to get for it? I don't know. Whatever the value of the shares are, if it's a good time to sell them, make out OK. If it's not so  great, maybe you don't do so well. Or kitty corner to that, here in the third  quadrant, a financial asset where you get a par value is predetermined how  much you're going to get, but you have to wait a specific period of time until you  get it bonds. So a bond, I buy a 30 year bond, and, you know, I give the US  government $1,000 today, and they go bankrupt, I don't know, 15 years from  now, and give me nothing, or ideally, 30 years from now, they give me my  $1,000 back. And then there's a strange quadrant right here. In the fourth  quadrant, a market value that you don't get until the future. This is just a future  or a forward. I'm not going to get into it. If you took a finance class, you'd know  what I'm talking about. But these are just, you know, the whole shebang. You  don't know what you're going to get. And you can, you have to wait until the  future in order to get it. So we've got four specific types of financial assets that  exist in the economy. And you can see that in particular when you save, when  we went back to you earning income and then having three streams that you  can spend them on. You add to your cash balance. You consume. Or you invest. You save and invest. Well, your savings and investment takes place through  either an equity investment or a bond investment. You either lend your money to somebody in the form of a bond, in which case, you wait, I don't know, 10 years  and you get it back with interest. Or you buy a stock or an equity investment and you can get it back. You can cash out whenever you want, but only at whatever,  whatever the prevailing price is. And notably, neither of these need to take place  through a bank. Like, if you think about your bank, what is the what is the main  reason why you go to your bank? Like the very fundamental reason why you go  to your bank not to take out a loan, not to take out a mortgage, you could do  that, but before you do that, you have to put money into your bank. You have to  make a deposit. And the fundamental reason that we go to banks is to convert  our currency into a deposit account. Like, I don't feel safe walking around  Auburn with these 35 cents in my pocket. So I'm going to go over to, I don't  know, the First National Bank of Auburn, or whatever it's called, and open up a  deposit account. I'm going to entrust them with my 35 cents. They'll keep it safe  for me. Fantastic. All I did was convert between different forms of money,  currency for a deposit, but it was still money at the end of the day. So this  specific quadrant is what banks are really in. The. Business of doing. And these  two quadrants have nothing at all to do with banks, at least in a free society, they possibly seem like they do today, but only because of this very legal, this 

balderized legal contract of the fractional reserve deposit contract, fractional  reserve deposit. So equity. Where do we go to buy equities? Go to the stock  market, fantastic. Or you could do it over the counter with with friends. You don't  have to go formally to the stock market. You could strike up equity contracts on  your own. Or the bond market. Where do you go to invest in bonds or to borrow  with bonds? Well, you can go on the bond market. You can go to financial  institutions that do this, but they don't have to be your bank. Notably, in futures,  I'm not going to get into because that's a that's a different kettle of fish. Now I  want to put this in a little bit of different phrasing. We'll see how you follow. So I  want to classify these risk and uncertainties into into a classificatory scheme. So again, the two big uncertainties you have with financial assets, or how much are  you going to get, and when are you going to get it? And of course, those  questions, you can either say, I know when I'm going to get it, or I don't know  when I'm going to get it. I know how much I'm going to get, I don't know how  much I'm going to get. And then we can classify in our four quadrants here, the  resultant risks or uncertainties that result. So if you don't know when  something's going to happen, but you know how much you're going to get, that's something that we could call structural risk, or something that is called structural risk, like, for example, I'm going to die. I don't know when it's structural risk. I  mean, could be tomorrow, could be 10 years from now, and probably,  statistically, it's going to happen when I'm I don't know, 79 years old. Clock is  ticking and and Alternatively, you could know exactly when something happens,  but not the magnitude. Hey, I'm going to give you something great if you meet  me behind the Mises Institute at five o'clock this afternoon. Yeah, you're  exposed to a lot of systemic risk on that one over the next the next three hours,  you got to wait to see what it's actually going to be. My van is parked out back,  yeah. And Alternatively, you could not know anything about the timing and not  know anything about the magnitude, and that would make you fully uncertain.  And again, that's why you hold money. Is to since we've already established that you hold money for these very uncertain situations, we know that you're holding  money to meet the uncertainty posed by this specific quadrant here, this  combination of uncertainty of timing and uncertainty of magnitude of your future  expenditures, that's important. It's not just blind. It's pertaining to a future  expenditure that you have to make. Now let's see how your financial assets  work within this quadrant system. So if you knew exactly when an expense was  going to crop up and you knew exactly what it was going to be for, great, no  problem. Settle it early at a discount. Like I know my rent comes at the end of  the month and I know how much it's for, I settle it early with my landlord at a  discount. You know, I save myself $25 a month, or whatever it is. I don't actually  do that, but could, or in the first quadrant there, if you didn't know when  something was going to happen, but you knew exactly what it was going to be  for, you could buy an equity investment, and depending on your risk, your 

propensity to take on risk. You could either take a risky investment, a risky  equity, like a high tech firm, or you could buy a blue chip stock, something that's  very stable in value. So I could buy what's a very stable stock these days, utility  stock, or which one Amazon is Amazon stable? I don't know much about it.  Okay. IBM, okay, some big, big blue chip stock with relative with relatively stable cash flows, I could buy a stock with that. The value is not going to change much. I don't know when something's going to happen, but it's okay, because when it  actually does happen, and I know how much the expense is going to be for, I'll  just cash out my stocks and I'll use that, or if you knew when something was  going to happen, but not how much you could buy a bond to just mature at that  moment in time when the expense was actually going to happen, right? Just  match the maturity of your investment to the perceived maturity of the event that you think is going to happen in the future. Or, of course, you would hold money if you were fully uncertain about all of these things. So in the last five minutes, I  just want to give you a quick, quick little model maybe you can use to think  about these things. So again, just to summarize, people save money according  to their specific perception of risk or uncertainty. And in particular, I don't like  calling your cash balance savings, but you put money into your cash balance if  you're completely uncertain about the future, and you hold money in equities for  those expenditures, where you don't know when they're actually going to  happen, or you put money in bonds when you know when something's going to  happen, but you don't know the magnitude of it when it's actually going to  happen. So on the saver side of of the model, we have some specific reasons of why they would be saving or putting their income into the three specific.  Avenues. Same thing on the borrower side, except borrowers don't don't borrow  cash. They either borrow through the bond or equity market. So they borrow  according to their preferences, and again, they borrow via bonds if the maturity  of their expense is known in advance, or with equities, if the maturity is unknown in advance. But in either case, the borrowers and savers are lending or  borrowing in money. And we can put this all together into a simple little model  that we call the loanable funds model, just to show the relationship between  savings preferences, borrowing preferences, and the resultant interest rate and  amount of money available to be lent or borrowed in the economy. So here  we've got the interest rate is on the y axis, and the x axis is just the amount of  loanable funds. This is the amount of money people want to borrow, or the  amount of money that people want to lend. I'm doing this in money terms. It  could be borrowing or lending in anything. But money is the easiest, and we  have a demand curve here. The demand curve is what, what type of people are  looking to borrow money. Well, borrowers, obviously, people with high time  preference, people that want to borrow money today in order to buy something,  in order to consume in the present. And then we have a supply curve, which is  composed of those people with low time preference, those who are willing to not

consume today, but to save their money and lend it to somebody else so that  that person can use it and then pay them back in the future, hopefully at a profit  or a higher rate, and the interplay between the supply and demand gives us the  interest rate that prevails on the market and also determines the amount of  funds that will available to be lent or borrowed. So here we've got $1,200 being  lent and borrowed in the market, and it's going to be repaid at an interest rate of  5% for a year, let's say, although the term is not so important, and then we could see what would happen with changes to savings or lending preferences. So for  example, what would happen if all of a sudden, many people increase their time  preference rate, or people in general became had a greater propensity to  consume in the present. Intuitively, you say higher interest rates, and then if you  go back to it, you would say, Well, that would be represented by a shift in the  supply curve. If people had a higher time preference and they started  consuming more today, that would mean less money available for them to  supply or lend to other people. And we could illustrate that by just a left word or  Joe, you like saying up and down when you shift curves, don't you an upward  shift in the supply curve. And of course, the upward shift, or the leftward shift,  represents the smaller amount of savings, and it results, or it determines, that in  that loanable funds market, there will be less money available to be borrowed,  which makes sense, given people are consuming more and saving less, but also that the price or the interest rate that you'll have to pay in order to borrow  money, or that you'll be remunerated if you lend will go up as well, will go up and as a as a response to that decrease in the supply of savings. And so throughout  this whole lecture, I just wanted to show you that to follow on and to build off  Professor Herbiner's Lecture in the in the previous the previous time slot.  Commonly, we all go to the banking system as our first origin for loans and for  investment products. Both savers go there to put their money and invest it, and  borrowers go to their banks in order to borrow money and fund their fund their  expenditures, and this doesn't have to be the case at all. In fact, it wasn't the  case for most of most of history, and it's a relatively recent phenomenon that the banking sector has taken on such prominence and become so important to the  detriment of other more traditional financing avenues, like equities and bond  investments. Thank you.