Money and Finance. Creation, features, and functions

1. А short introductory look at that mysterious and virtual World of money and finance

Prof. dr Stanko Radmilović

Back in the eighties, some of the most prominent Yugoslavian economists confided/complained to me that as “non-monetarians” they can hardly understand and follow discussions and articles regarding monetary and financial topics: that field, as they said, was somehow abstract, imaginary … I assume that for them, as well as for many economists from younger generations, not to mention non-economists, businessmen/”practical businessmen”, politicians, etc, the World of money and finance is not less abstract and totally transparent even today, after the “financial revolution” “happened” during the previous three-four decades and after the current global economic crisis, if not primarily generated, at least emerged from this field.

Indeed, the contemporary World of finance can hardly be essentially explained and understood if it is observed as an enormous amount of monetary and financial activities which we meet or hear about at every corner: about issuing of money, restrictive or expansive monetary policy, loans and interests, credit cards, cheques, imballances, etc; about numerous accounts at various financial institutional entities, local and foreign currency balances; about audits and supervision; about shares, majority and minority shareholders; about foreign direct investments… portfolio and greenfield investments; about electronic money and electronic payments; about stock exchange and OTC operations, including the electronic forms of trading in securities; about the international financial integration and globalization; and especially about terminology which is still not very much present in our everyday lives, such as the “industry” of pension insurance and some other forms of “industrialization” savings, financial products…; then various kinds of risk management, financial hedging, financial derivates…; and to complete the illustrative numeration with what is perhaps the least understood and it is that, in spite of numerous measures and instruments for hedging, i.e. distribution of risk, it cannot be denied that there is a financial imbalance, financial instability and financial crises, such as - let us mention only a few – the Mexican (“Tequila”) financial crisis, East-Asian financial crisis, Russian currency crisis, Argentinean crisis, and also some financial scandals in large world corporations (microeconomic instabilities, crises and collapses), such as Enron, etc.

Bearing all that in mind, it is understandable that, not only laics, including the “educated laics”, but also a large number of financial experts, seem to have the impression that it is about the special World of money and finance, the World of heterogonous, not connected, unsynchronized and even chaotic financial transactions and balances, the World ruled by chaos, probably caused by a sudden, dramatic financial development, which is (not only figuratively) often called financial revolution. It is certain that all this exist to some extent, but it is even more certain that “there is a system in that chaos”. Nowadays, it is a generally accepted fact, not in a general sense anymore, but in term of the existence of precisely defined and in practice achieved financial systems, primarily national, regional to a lesser extent (such as the EU Financial System) and the lest in term of a well-functioning international, global financial system.

In other words, the highly complex World of money and finance is today less in accomplishment and more in a tendency, attempts and practical efforts, “systemized”, i.e. organized as a monetary and financial system in various frames (national, regional, international). Of course, not only because it would make it easier to understand, but primarily in order to be regulated, homogenized and controlled as much as possible... In other words, in order to function properly.

Therefore, in order to understand the contemporary World of finance, the “system approach” is necessary (whatever that means). But, a “shortcut” could not lead to necessary understanding: that by medias res we head towards the most complete, official definition of the financial system and then to deal with the apparent elaboration of its elements. If a comprehensive theoretical analysis is not necessary, then at least a thorough insight and elaboration of those aspects which make it possible to understand the essence is necessary. Such approach will easier and more completely explain many alternative and more developed categories. For example, with a good enough understanding of terms money and finance, one can understand that it is not only a rhetorical question, empty phraseology that the colloquial phrase “the contemporary World of finance” is observed not only as a complex system with various sub-systems, but that “World” is also more and more treated as industry of financial services, as a financial industry – not only in the USA, where it is much more developed, but also in the European union, and in documents and practice of the World Trade Organization.

In this sense, it is logical to assume that in order to have a better and more complete comprehension of the World of money (monetary system, monetary policy, etc) and finance (financial systems, financial services), one should start with questions which might seem trivial or “bookish” at first glance: what is money and what is finance, what are the similarities between them and what are the differences. If they are not full synonyms, and we will see they are not, then many crucial questions arise, out of which at least the following should be mentioned:

- What is the relationship of the new, but now already established category of the financial system with the well-known “old” category of the monetary system?
- What are the differences and the relationship between the financial and monetary (price) (in)stability?
- What brought the conclusion that establishing of monetary (price) stability does not automatically provide financial stability as well?
- What is the role of central banks in establishing of financial stability?

No matter how good and complete answers to these and similar questions are, there will be no in-depth understanding and practical actions unless the concept of today’s fiat money is clarified, together with the concept of finance. Only then, let us say immediately, their organic, even “Siamese” link and yet huge individuality will be fully understood.

2. Money – underlying and key category for understanding of the World of money and finance; controversies about the monetary system

Prof. dr Stanko Radmilović

It has been already mentioned in other texts and it is generally well-known that it is confusing and even mysterious for most people that money, although being representative nowadays (a piece of metal or paper without value, or even some recording position), it is very important in people’s everyday lives and activities. Since it can be heard “on every corner” that this very money (finance) has caused a severe global economic crisis we are going through, that mysteriousness has occurred. How is it possible that something so “worthless” can actually have such a powerful virtual effect?

Clear answers to such questions can hardly be provided only from reference books, dictionaries and encyclopaedias, overloaded with loose category definitions. They cannot be provided even from textbooks written either by the principle of “endless copying” or with the intention to colour rating of certain subjects, if they are not mysteriously complicated, not to make them trivial and less important.

In order to demystify and perceive clearly what that virtuality consists of, “unreal but yet real power and importance”, it is necessary to get to know the essence of money itself, so that the whole “financial industry whose main raw material that money is” can be understood, as stated by Scholtens and Wensveen (2003). By this symbolic statement, the authors actually referred to the fact that the category of money singles out by being the main and organic part of a huge category corpus, from which only the following should be mentioned, for the sake of a small illustration: functions of money in economy as well; the way it is created; monetary politics; the system of handling money, i.e. the financial system and its functions; monetary and financial (in)stability (these are neither synonyms, nor pleonasm), etc.

Of course, regardless of different points of view that have already been discussed, money is not important “since yesterday”. However, this text does not tend to elaborate historical development and evolution of money, unless absolutely necessary. Therefore, this text deals only with things which are necessary in order to understand “the current state of affairs”.

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It might not be of vital importance, but still, for the sake of sufficiently comprehensive explanation, it should be mentioned that from former full-value money to today’s fiat money, the evolution has passed the road with three main phases (for the sake of simplicity, only the transition sections are abstracted):

1. Types of full-value money (primarily golden, then silver and some other forms to less extent);
2. Fiat money (mostly cash, primarily coins and later banknotes) which could be fully exchanged for full-value money at any time, or for a substance of full-value money (gold, silver, etc);
3. Fiat money with obligatory partial coverage in gold (somewhere in silver) which the central bank had to have for cash in circulation, which served as a measure for its value;
4. Fiat money, not only cash, but also deposited money, with identified parity with gold (Gold exchange standard), which served as a measure of its value compared to the money of other countries.

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