Wednesday, February 25, 2009

Essential guide to language in the 21st century economy

These words will help you to understand 21st Century economy stats

Bad bank A financial institution, or part of one, that looks after a bucket of debts that may turn sour. Strictly speaking it is the loans, not the bank, that is bad. Good banks, and especially talented bankers, are needed to orchestrate bad-bank salvage operations.

Bear a pessimistic investor

Bull a stock market investor with an optimistic disposition. Only sceptics reckon bulls talk rubbish.

Certificates of deposit Sometimes, in finance land, jargonised names are more self explanatory than the innocent observer might think. A “certificate of deposit” is exactly that, a document that represents a deposit, often at a bank. All other things being equal, a CD is worth the amount deposited with the bank. Think of one like an old-style building society pass book, if you like. The owner receives all the interest payable on the deposit, just as if the holder of a building society pass book received all the financial goodies payable. Why do CDs exist? They usually have a fixed life span, and because they do, banks know that the can rely on having the funds in the coffers for that time. For their part, depositors get a better interest rate by agreeing to the lock-in. Because CDs are tradable, the original depositor can get his or her hands on money before the end of the pre-agreed term, by selling the CD – together with all the rights and responsibilities that go with it - in the second-hand market. Proper CDs are among the most boring and reliable investments there are. In the Stanford case, it seems that financial instruments called certificates of deposit were weird mutants, or not real CDs at all.

Commercial paper Promises, made by companies, to pay. Invoices, which are glorified IOUs, represent one variety of commercial paper. The IOU may be a promise to settle an unpaid bill for work done; it may be a promise to repay a loan.

Credit insurance Guarantees given to banks, and other lenders. With government-backed credit insurance, the lender will not lose money even if the borrower welches.

Creditors People who lend money, or those who are in credit

Debtors People who borrow money, or those who are in debt

Deflation What happens when things get cheaper. While many might think falling prices are a good thing, it is bad in at least three key ways. Firstly, if the price of stuff is going down, consumers will be tempted to wait before buying. Since tomorrow never comes, steady reductions in prices means that stuff never gets bought. And if falling prices becomes a widespread problem, companies stop making stuff, the economy stagnates, shops empty and people lose their jobs. Secondly, falling prices means that companies get less money for selling goods and services. If revenues fall, there is less money knocking around to pay wages and companies reduce their wages bills by stopping over-time, or making people redundant. If they do that, prices continue to spiral downwards because there is less money around to spend. Thirdly and most scarily, deflation increases the real, underlying, weight of debts. The size, in pounds, dollars, euros or yen, of a mortgage does not change, but if you earn less, it will take longer to pay the interest and pay off the capital. Governments hate deflation because they are habitual borrowers, and the last thing they want to do is spend a larger part of their declining tax revenues on paying interest. Those with mortgages should be similarly fearful. Although inflation is disliked, it is seen as the better of two evils - not least because inflation lightens the underlying weight of outstanding debts.

Depression When recessions get really bad, they become depressions. Unlike recession there is no widely accepted textbook definition of a depression, although some say it comes when GDP shrinks by a total of 10 per cent. It will feel distinctly like a depression if a recession goes on for more than a year. After two years, talk of recessions is sure to be replaced by ultra-glum references to depression.

Dove an observer who is believes that friendly economic levers (such as interest rates) should be pulled

Fractional banking this lies at the very heart of the credit crunch, and near the centre of most, if not all, financial crises. Fractional banking is widely deployed and sees banks lend much more money than they hold in deposit. Deposits of money, in other words, are a fraction of the amount of money created as debts to businesses, individuals, governments and homeowners. Fractional banking is a force for economic good – it means that many more people can use the money to buy things they want, to build factories and create jobs, and to engage – generally – in economic activity that improves standards of living. Fractional banking is inherently unstable, however; if depositors want their money back for any reason banks can rapidly run out of funds. Confidence plays a key role, and if confidence dissipates, the unstable boat that is fractional banking can quickly become swamped, and then sink. Once a run on the bank starts it rapidly becomes catastrophic for the institution concerned. As a rule of thumb, sound fractional banks lend out the equivalent of £10 for every £1 of safely-deposited capital they hold. In the lead up to the credit crunch, some banks lent out more that that and were consequently more vulnerable were confidence began to disappear.

GDP A number that represents the size of national economies. It is a measure of economic activity. GDP is usually referred to in terms of the change on previous periods and since relatively sound economies grow, over the long term, at about 3 to 5 per cent a year, even small-looking percentage changes in GDP can have a dramatic impact.

Gilts Government debt. When the state borrows money, it borrows from institutional and, or, individual investors. Normally, the British Government sells gilts in exchange for hard cash to spend on things such as education, health and defence. At present the Government is issuing gilts in exchange for commercial paper in the hope that the exchange will increase levels of trust in the financial system. (NB “Gilt” is a nickname: the full name is “gilt-edged government security”. Why? Because in Napoleonic times, when the British Government started borrowing in this way, the IOUs were written on paper edged with gold leaf. It was a sign of the reliability, or creditworthiness, of the Government-borrower.)

Hawk someone who thinks that you have to be cruel to be kind when it comes to economic policy

Hyperinflation is to inflation what depression is to recession: the same only much worse. Opinion divides as to textbook definitions: but inflation that runs at 10 per cent or more a month, or 100 per cent or more a year, is hyperinflation. When inflation gets really bad it destroys faith in currencies, and when faith in currencies dissolves, economic activity goes down the drain. Money helps trade, and helps build complex - hopefully civilised - societies. Without money, civilised societies are weakened, and inefficient bartering takes the place of more advanced, better, forms of life-enhancing trade.

Inflation The fancy name for rising prices. Inflation is bad for lots of reasons. It is bad because it creates economic instability. Companies are always uncertain about the future, and that makes it hard for them to plan. If inflation is high, the sense of uncertainty rises and companies may play safe and decide against developing new products, building factories, and employing staff. High inflation therefore stunts economic growth, in the long term, although in the short term, a little inflation serves as economic encouragement.

Leverage A fancy name for debt often expressed in proportion to a borrower’s assets. Also known as “gearing”.

Liabilities Debts

Liquidity A fancy name for money. The more liquidity in the financial system, the more money there is sloshing around. If liquidity is scarce, as now, there is only a small amount of money in the system. The Government is attempting to improve liquidity by replacing low-quality commercial paper with high-quality gilts. It is crucial, in this context, to understand that cash is only one type money. Money is anything that is used in the exchange of goods and services. Gold bars, IOUs, hire purchase agreements, and mortgage debts, are some examples of “other” sorts of money. Different types of money have different qualities, some are good, some are bad, most are in-between. The quality of money shifts, over time, as economic circumstances change. The quality of money also changes as people, particularly people who are also investors, adjust their opinions.

Ponzi schemes alarmingly simple but powerfully deceptive investment schemes – especially if you are the gullible type. Also known as “pyramid selling”, the schemes often start with a genuine investment idea but become derailed in order to line the pockets of fraudsters. They work, temporarily, by paying mouth-watering investment profits out of fresh investments of new investors’ cash. Ponzis might be compared to a hose pipe. As long as water (that is, money) goes in at one end, water (that is, more money) comes out at the other. And as long as the water flows, the founders siphon off a fat share of the loot for themselves. But as soon as the tap is turned off, the whole kaboosh is seen for being the hollow pipe-dream it really is. Ponzi schemes are named after an Italian-American by the name of Charles Ponzi, one of the most famous fraudsters of the ilk.

Profit margin an indicator of profitability rather than just profits. It is calculated by dividing the turnover (aka sales or sometimes revenues) of a company by its profits to get a percentage figure. For example: imagine that Lollipop PLC sells £1 million-worth of lollipops in a year, and makes a profit of £50,000. Its profit margin is £1 million divided by £50,000 or 5 per cent. Now imagine that Gum PLC sells £10 million of chewing gum and makes £250,000 of profit. At first glance it might seem that Gum is doing better. But since Gum's profit margin is only 2.5 per cent, you might say that the opposite is true.

Preference shares Financial agreements used by companies to raise money. Companies usually raise finance in one of two ways. They either issue shares, selling ownership right and responsibilities in exchange for the cash raised. Companies also borrow, often through the issue of glorified IOUs called bonds, that confer no rights of ownership. Preference shares are a hybrid: they get dividend before holders of ordinary shares, but come lower than bondholders (x-ref creditors) in the pecking order.

Quantitative easing A posh way of referring to the process of printing money. It is a horrible piece of jargon. The hope is that if Governments print money, and inject it into the economy, people and companies will be more likely to spend. If they are more likely to spend, there is a greater chance that the economy will spring into life. Take a bar-room illustration: the bloke at the bar with a fistful of dollars is more likely to splash out on a round than the man who is down to his is last nickels and dimes. Even if the cash is borrowed, greater quantities breed greater generosity. How does quantitative easing take place? The Government, or its agents in central banks, replaces poor-quality money in the economy with good money. Old IOUs issued by companies that may welsh on promises to pay up are replaced with IOUs underwritten by the full force of the state, and its ability to raise tax revenues. It is like printing money because the old IOUs because useless. Replacement, in other words, is akin to creating new money. And by boosting confidence some forms of money (that is, corporate IOUs and the like), it is hoped that confidence across the economy will rise.

Recession Wags would have you believe that a recession happens when your neighbour losses his or her job, and it is a depression when you are made redundant. Economic textbooks tell that a recession is what happens when the economy shrinks for six months on the trot. GDP is used to measure the size of the economy, and when the figures go negative for two successive three months periods (or quarters) the technical definition is met.

RPI Stands for retail price index and is a measure of changes in the cost of living. If it is positive, we have inflation. If it is negative we have deflation. The RPI is only one measure of inflation as calculated by National Statistics, the UK Government agency although it is important because, among other things, it is the one used for increasing state pension payments. The Bank of England's Monetary Policy Committee, which sets UK official UK interest rates, uses another measure - the Consumer Prices Index, or CPI, largely because it is closer to the measures used across Europe. The CPI like the RPI except it excludes things such as council taxes.

Sub-prime Equals dodgy. Sub-prime borrowers are people who prove themselves unable to repay what they owe. Sub-prime loans are debts that may not be repaid. Sub-prime mortgages are home loans where the debt will not be settled even if the house on which it is secured is sold because the property has fallen in value.

Systemic threat A threat to the whole financial system, rather than just a part of it. Government is obliged to act against systemic threats because failure may bring financial Armageddon. Banking failure is systemic because banking (that is, the practice of exchanging money, goods and services between people) is everywhere. In extremis, a country can do without a motor industry. Modern society would collapse if banks ceased to exist because money would cease to exist.

Toxic debt Loans that may not be repaid. They are especially scary because of the risk that one toxic debt may poison other loans that were previously OK. For example, if one home loan on one street goes bad, it might make people think that all the loans on the street will go bad.

Writedown If a company, or a bank, thinks that it might lose money it “writes down” the value in its ledgers. The company may or may not actually lose the money, a writedown process is a precautionary move – albeit one that often leads to “write-offs”.

Write-off Like a car involved in a bad accident, a loan that won’t be repaid is written off. Prior to the accident, the car will have value. After it, it does not. Ditto for money involved in a credit accident. Where does the money go? It disappears, with the resulting gap being eventually reflected in the year-end tally of corporate or governmental profits and loss.

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