The third aggregate market we will examine is the capital market, probably the most heavily regulated market but also the most dynamic. In the past twenty years, as a result of rapidly changing communication and computer technology, we have witnessed the growth of new financial instruments, financial institutions, and financial markets against a backdrop of increasing globalization. And with these changes came problems. In the 1980s it was the Savings & Loan crisis that was centered in Texas, in the early 1980s we witnessed the closing of the state's credit in Rhode Island, and in 1997-98 it was in the emerging capital markets in Southeast Asia and Latin America.
In addition to its dynamism, the capital market is also characterized by its complexity. To help you envision the market, look at the situation facing Mary, a successful entrepreneur, as she sits down to pay her bills on the first of the month. Mary writes checks to Aetna for her car insurance, and to Northwestern Mutual for her life insurance; she deposits some money into her savings account at Citizens, her mutual fund at Fidelity, and her retirement account managed by Fleet; she calls her broker at Merril Lynch to have her buy some stock in American Power Conversion and some AT&T bonds; and she writes checks to Commonwealth Credit for her home mortgage, Adelphi Credit Union for her installment loan on her car, and Bloomingdale's to pay off her credit card balance. She has been working overtime in the capital market.
It is possible, however, to develop a working knowledge of the capital market without becoming lost in the details. At its simplest, the capital market has two functions. The capital market is where assets are exchanged and where funds are transferred from those who at some moment have more than they need to those who have expenses that exceed their income. Financial institutions are in the business of facilitating the flow of funds between the borrowers and lenders. To understand their role, consider the problem confronting individuals and companies that want to borrow money for a specific period of time. They must find someone willing to lend them just the right amount of money for just the right length of time. Because of this need to transfer funds, and the difficulty of making the correct match between borrower and lender, financial institutions evolved and they have developed a wide array of financial instruments. In the remainder of this section, the structure of the capital market will be briefly described. More specifically, we will attempt to answer briefly the following questions.
As we proceed, keep in mind that the distinctions between the various financial institutions are changing rapidly and new financial instruments appear almost weekly. The analysis of the capital market will conclude with a brief introduction to interest rates - the price of money.
What is the significance of the capital market?
The capital market, often referred to as the financial system, plays a pivotal role in a market system. It is the financial system that facilitates the flow of funds between buyers and sellers in the various markets, it allows the plumber, teacher, and banker to specialize in what they do best and for society to minimize the efforts / resources devoted to the transactions that must accompany any specialization. You will recall that Adam Smith was the first economist to point out the benefits to specialization and the capital market is the facilitator of the specialization.
A financial system also stimulates borrowing and saving. A key to economic growth is investment spending on new machines and factories. For our plumber and carpenter, this meant better tools, and anyone who has done plumbing and carpentry knows the time savings of better tools. But where would we find the funds to purchase the tools? From the recycling of the savings of others. If it were not for the savings, the surplus of production above that earmarked for consumption, there would be no way to find the resources necessary for spending on machinery which produces no direct, immediate benefit to the consumer.
It is no surprise therefore that the former Eastern European countries attempted to develop capital markets as they struggled with their conversion from command systems to market systems. If they were to establish an array of markets in the real sector for the exchange of goods and services, they would need to establish the financial markets needed to provide the money for these transactions. The capital market functions as the set of pumps and hoses that delivers the oil where it is needed, to the markets. Firms come to the capital market to finance their investment projects and to invest their surplus funds; households use the capital market when they borrow money to buy a home or a car and when they invest their surplus funds in savings accounts, stocks, bonds, mutual funds, life insurance policies, or pensions for later use; the government goes to the capital market every time that it needs to borrow to finance its deficit; and foreigners come to borrow money or invest it.
And when the oil stops, we know the consequences. The economic engine that generates jobs and goods seizes up. In the US, the most notable seizure by far would be the stock market crash of 1929, the opening event of the Great Depression of the 1930s. In the aftermath of the crash, the nation's banks took 'holidays' and shut their doors and the money needed to keep the engine running smoothly disappeared. You may recall the scene from the Jimmie Stewart movie that plays each Christmas season "It's a Good Life" when the Bailey's Building and Loan (a bank) is threatened by a rush of people looking to get their money out. Imagine if employers could not get the money to pay wages and salaries. People would not be able to pay their mortgages and car payments, they would be unable to purchase food at the supermarket or clothes at the mall. It would not be long before the workers who produced the food, the clothes, and autos would find themselves out of work. By the time we were done we would find massive unemployment in the labor market and idle factories and offices in the output market. In the US at the height of the Depression, unemployment peaked at 25 percent of the labor force.
To make sure that the oil keeps flowing the government has heavily regulated the capital market, in part because of the widespread perception among policy makers that the capital market shock was the cause of the Depression. The agency primarily responsible for regulating the capital market is the Federal Reserve (FED), the central bank of the US. Since its inception in 1914, the FED has exerted considerable influence over the workings of the capital market, both indirectly by establishing the rules governing the 'behavior' of the major financial institutions operating in this market, and directly by controlling the nation's money supply. The Fed is the monetary authority in the US and the agency responsible for the conduct of monetary policy, something we will discuss at length in our later discussion of macro policy.
Who are the major players in the capital market?
A detailed description of the important financial institutions and instruments would fill a rather large book and would be obsolete by the time it hit the presses. Fortunately, it is possible to get the flavor of the capital market with a brief overview of a few important financial instruments and institutions. Let us begin with financial institutions, firms that are primarily in the business of buying, selling, and holding financial assets. A few of the major institutions are listed below.
Investment banks differ from the other financial intermediaries because they do not issue their own financial instruments. You would work with an investment bank if you wanted to buy stock in a company, or if you wanted to take your privately owned company public and issue stock. The difference between investment banks and mutual funds can be seen in the diagram below. In both cases the flow of funds is from the households (lenders) to the corporations (borrowers). The green lines represent flow between the lender and the borrower when there is an investment bank. The investment bank would take its cut of the transaction, but it would be a direct exchange between the two principal parties - the borrower gives up the $s and gets the stock certificates.
The Capital Market
When there is a financial intermediary such as the mutual fund, however, there is an additional important step. In this situation the lender gives the money to the mutual fund who then uses the money to purchase stock from the borrower. Rather than giving the lender the stock, the intermediary issues its own instrument - in this case the mutual fund issue a share in a share in the fund which is then given to the lender.
It is this intermediate step where a new financial instrument is created that is the common denominator among financial intermediaries. Historically the structure of the primary financial institutions' assets and liabilities differed dramatically, but in recent years there has been a marked tendency for the institutions to invade each other's turf. For example, on the liability side of the balance sheet commercial banks for years had a virtual monopoly on checking accounts. If you wanted a checking account, you had to go to a commercial bank, but times have certainly changed. First there were the savings banks offering NOW accounts which are savings accounts that act very much like checking accounts and then there were the mutual and money market funds that provided check writing. On the asset side, savings and loans, which were once restricted to home mortgages, moved into commercial loans as a result of changes in federal legislation, while commercial banks, after losing some of their traditional corporate customers to the commercial paper market moved increasingly into real estate loans. Life insurance and pension funds, meanwhile, joined commercial banks in the market for real estate loans which caused some real fears of another savings and loan type fiasco during the collapse of the real estate market in the northeast during the recession of 1989-91.
Before moving on to discuss the financial instruments, some brief comments are in order for one additional financial institution - the Fed (Federal Reserve). The Fed is the central bank of the country and you can think of the dollar bills in circulation as the Fed's primary liability. By changing the level of dollars in circulation, which it alone has the power to do, the FED has the ability to alter the money supply - a process we will look into in detail when we examine monetary policy in the 1970s.Who are the major financial instruments and markets in the capital market?
Just as a detailed treatment of financial institutions is impossible, so is a detailed description of the primary financial instruments. The market is in a constant state of flux with new instruments being invented continuously, but even a casual reading of the financial pages of magazine and newspapers or cocktail party conversations will expose you to many of the important instruments. Some of those instruments are listed below.
For a detailed treatment of these instruments you would want to invest some time in learning about what would traditionally show up in a finance course. You might also check out the on-line references (Business terms and Financial terms). What you will find here is a primer on two of these instruments - Stock and Bonds
It is also possible to differentiate markets by a number of additional characteristics. Some of the distinctions you are likely to hear used are between the markets where new assets are sold (Primary) and markets where existing assets are sold (Secondary). The most notable secondary market would be the stock market. There is also the distinction made between the money and capital markets. The money market is where short-term debt [securities with maturity less than a year] are exchanged while the capital market is for corporate stock and long-tern debt [securities with maturity over a year].
Another distinction is made according to when the asset is delivered. Spot market are for assets delivered soon, Futures market for assets delivered at future date, and Options are market for assets conditionally delivered at future date. For more information on the options you might want to check out some on-line guides a primer on options and a guide to options. In the options market two terms that you may run into are a call, where you can buy at certain price before certain day, and a put, where you can sell at certain price before certain day.
In recent years the financial instrument that has received the most press are derivatives. These rather obscure instruments first gained notoriety when Orange County in California lost billions in derivatives and then reemerged in the limelight in 1998 when George Soros' fund lost billions on Russia and Long-Term Capital needed to be bailed out by a consortium of banks under the direction of the Fed. Although the term derivatives covers a broad range of assets, the common denominator in all is they are based on bets about future prices in the capital markets. In the case of Long Term Capital, the bet they lost heavily on was the spread between interest rates on long term government debt and long term corporate debt.Before we leave the capital market we will turn our attention to a key indicator of developments in the capital market - interest rates. We will examine the link between various interest rates and the link between inflation and interest rates. In later sections we will examine the linkages between the capital market and the other macro markets, especially the output market, in an effort to better understand the impact of monetary and fiscal policy on the performance of the macro economy.
To fully understand interest rates you would need to invest a considerable amount of your time learning about the details of the capital market, but fortunately you can gain considerable insight into interest rates with a modest investment. As you read about interest rates in the financial press, you should keep three points in mind - interest rates are prices, there are many interest rates that tend to move together, and there are many components to each interest rate. In this section we will discuss these three points plus briefly describe the history of interest rates in the past thirty-forty years. A more thorough treatment of interest rates appears in our discussion of the 1970s.
A starting point in an analysis of interest rates should be the recognition that the interest rate is a price, the price of money, and the model of prices we discussed earlier is an appropriate framework to analyze prices. When we talk about interest rate movements we will be talking about shifts in the supply and demand for money curves. In this course when we talk about interest rates, we will seldom talk about specific rates, although what you care about are the specific rates. You care about the rates on your loan or your bank account, while policy makers may care about the government pays on it's debt. The good news is that they are all closely related. Because interest rates tend to move together, although the fit is not a perfect one, we will simply talk about interest rates. When we talk about rising interest rates you should expect to see your loan and bank account rates rising. The relationship between various interest rates is evident in the graph below. Interest rates on loans to local governments (Municipals), low risk corporations (Aaa bonds), and the federal government (Treasury 10 year bonds) tend to move together.
There are a few rates you may want to know about as you sort through the financial press, rates that we will talk about later.
The differences between rates can be best viewed as the result of the fact that each loan / lending has different characteristics, just like DVDs and apartments have different characteristics. An interest rate is the price of borrowing, and not all borrowing is the same. For example, you would charge less to a borrower who you were confident could repay the loan, and you would charge more if you expected dollars to be worth less when the loan was repaid. When you look at interest rates, therefore, you should think of them as reflecting a number of important criteria that affect the lenders decisions. One such set of criteria, that we will explore in detail in the 1970s, appears below. The interest rate quoted to you, the rate you actually pay can be decomposed into five separate components - default effect, inflation effect, maturity effect, liquidity effect, and the real scarcity of funds. Riskier loans carrying a higher interest rate since if you are to be coaxed into lending money to a riskier venture, it will only be if you are offered a premium to compensate you for your greater level of anxiety over the likelihood of repayment.
What are the determinants of one's perception of risk? First, there is the ability of the borrower to pay back the money - default effect. This is why we have bond rating companies to assess a potential borrower's fiscal health. The difference between corporate Aaa bonds and federal government bonds can be in large part attributed to the market assuming that the default risk for corporations is higher than it is for the government. The default effect is also influenced by the ease with which a lender can recoup its losses in the event that the borrower can not meet the repayment schedule. Generally speaking, interest rates are lower when the borrower offers more collateral, assets to be taken over by the lender in the case of default. This is why the rate on home mortgages are lower than car loans which in turn are lower than the rate on personal loans.
Time to maturity is an additional source of risk. Given our inability to accurately predict far into the future, anyone lending money for a long period of time will generally require a higher rate of return to compensate for the higher perceived risk - maturity effect. You can see this in the graph of long-term and short-term lending where the rate on long-term 10 year bonds are substantially higher than the rate on 6 month bonds.
Interest rates are also influenced by inflation rates - the inflation effect. The time-series graph below clearly indicates a positive relationship between interest rates and the inflation rate. As you would expect, when lenders see higher inflation rates they will want to receive higher returns on their loans and borrowers will be willing to pay higher rates because the dollars when they are repaid are not worth as much as when the dollars were lent out.
To see the impact of inflation on interest rates, let's look at a simple example. Assume you borrow $100 today and promise to pay back $105 one year from today. The lender will have been paid $50 for the use of that money for a year and the lender will use the $105 next year to buy a new pair of sneakers.
It sounds like a mutually beneficial trade, but what happens if the price level changes? The mathematics of the example have been worked out below.
When 5% is not 5%
Nominal rate 5.0% 5.0% 10.0% Inflation rate 0.0% 5.0% 5.0% Real rate 5.0% 0.0% 5.0% Loan $100 $100 $100 Interest paid $5 $5 $10 Total payment $105 $105 $110 Cost of living $100 $105 $105 Gain to lender 5% 0% 5%
Column 1: you pay 5% interest in zero inflation world. When you repay $105 in one year, the lender can buy $105 worth of 'stuff'. The lender's buying power has been increased by 5% by waiting a year. The real rate of return is 5%.
Column 2: you pay 5% interest in 5% inflation world. When you repay $105 in one year, the lender can buy $105 worth of 'stuff', but the cost of living has risen 5%. This means it now costs $105 just to stay even, to buy what we used to buy with $100. The lender's buying power has not been increased by waiting a year. The real rate of return is 0%.
Column 3: you pay 10% interest in 5% inflation world. When you repay $110 in one year, the lender can buy $110 worth of 'stuff', but the cost of living has risen 5%. This means that the lender now has $110 and costs are $105 just to stay even. In this case the lender's buying power has not been increased by 5 % as a result of waiting a year ($110/$105 = 5%). The real rate of return is 5%.
Are there any generalizations we can make from our simple example? If we ignore all of the other components/dimensions of the interest rate, we can specify the relationship between real and nominal interest rates as follows:
rn = rr + ie
rr = rn - ie
- rr = real rate
- rn = nominal rate
- ie = expected inflation rate
It turns out that the distinction between real and nominal rates matters a lot. The differences are apparent in the table and graphs. There is very little association between nominal and real rates.In the late 1970s real interest rates turned negative as lenders took a beating because the interest rate increases did not keep up with spiraling, unanticipated inflation. As a result of the recessions in 1980-1982, inflation dropped sharply, but interest rate declines failed to fully reflect the disinflation. A substantial rise in real interest rates was the result. In the 1980s, the real interest rate on 3 month government securities rose nearly 5 percentage points - a pattern we saw duplicated in the recession of 1990-1992.
The second feature of the interest rate graphs is the apparent break in the upward trend which occurred in the early 1980s. There were two events in the 1970s which helped push up the inflation rate into double digit ranges. The first were the two OPEC price increases which put extreme upward pressure on prices as firms attempted to raise their prices to compensate for their increased energy costs. The second was the freeing of the world's monetary authorities from any external constraints as the world went off the gold standard. For the first time in the post W.W.II period, monetary authorities of all countries were free to print as much money as they desired. The result was a surge of the world's money supply which was quickly reflected in higher price levels and inflation rates. The dramatic break in the inflation rates in the early 1980s was the result of a change in policy at the FED, the U.S. central bank, and a decline in world oil prices accompanying the recession of the early 1980s.
Short-term Government Rates
Nominal Inflation Real 1950-59 2.03 2.25 -0.22 1960-69 4.00 2.53 1.47 1970-79 6.32 7.41 -1.09 1980-89 8.85 5.12 3.73 1990-95 4.87 3.33 1.53
Real Interest Rates
We have now finished an overview of the capital market including a discussion of interest rates. It is now time to move on to the last market, the foreign exchange market.
In this section we have focused on the capital market, the market in which funds are moved from those with a surplus of income over expenses to those with a surplus of expenses over income. The intent was that you should have an understanding of some of the information that appears in the financial pages of national newspapers - information concerning stocks, bonds, and interest rates.