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Financial Markets

9 minutes
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What is the purpose of a financial market? There's a few theories that discuss why we have financial markets. Thomas Malthus was an 18th century British philosopher. He's famous for this idea about why populations grow. His ideas this, there's resources, and there's people and people consume these resources, this food, water and so on. And at a certain point, the population grows so much that there's not enough food to go around.

At this point, people start, they die and the population goes down. At a certain point, there's so few people that the resource to start accumulate and has enough resources for people to survive. So they start to eat more and they start to reproduce more, but then the population keeps growing until eventually you're back at the start again. So this was a very persuasive idea. Even Charles Darwin got a lot of his ideas. Thomas Malthus and these ideas became so convincing that the British Parliament started enacting laws based around this idea that we don't want the population to grow so much that they outgrow all of the food and resources.

So, the British Parliament actually created these work houses for the poor, with restricted calorie diets for these poor people. And they even spiked the food with certain things to restrict the sexual drive of these people. And this is where you had these awful working conditions. And you have these stories by, for example, Charles Dickens with Oliver Twist is essentially an orphan, a kid who has no no family, so he's sent to work in a workhouse where people who have no means of any education or money, they just have to work. Now this was a very unpleasant area to live in, and Charles Dickens also wrote the book The Christmas Carol, which is a story exactly the opposite saying why are we living in these conditions? And why are we not being kinder to people?

Anyways? So it turns out Thomas Malthus was actually wrong about a lot of this theory. He made some incorrect assumptions. He assumed that populations grow exponentially, and that's why we would ouch grow our resources. But it turns out, they don't do that. Once you get to a certain income level.

Once you meet a middle income level, the number of children that a family has tends to decrease. Also, Malthus assumed that output would be constant. But it turns out that the amount that is produced with the population also increases as the population increases. So this might be more resources to a certain extent, as the population grows So we had to come up with another theory. In 1912. Joseph Schumpeter came up with another theory.

Joseph Schumpeter is an interesting fellow. He had three goals in life. He wanted to be the greatest lover, the greatest horseman, writer, and the greatest economist. And later on, he claims that he accomplished two of those three things. Although he didn't specify which things they were. He was a bit of a rebel as well.

When he was in school, he kept getting in trouble because he would go around and hang out with prostitutes all the time. One of his professors, they asked them, please stop associated with prostitutes. And in response, what he did is he hired for prostitutes to go for a ride with him in an open horse carriage and just rode around town with them. Anyways, so he turned out to be brilliant of Finance. He went to one of the top financial schools and his idea is this. There are two ways that companies can compete.

They can either lower prices Or they can innovate better. And this idea that comes out of this is now known as creative destruction. And it's the idea that innovative companies, when they win big, they come up with a product that is new. And that product essentially creates a market just for that company. They essentially create a monopoly where they're the only company selling that product or service. So they get all the business.

And every time any innovative company comes along and doing this, they've disrupted the entire market. So whatever equilibrium there was between the supply and demand of the goods is now changed. And that's why this market equilibrium moves all the time is because innovative companies coming around. So that's what Schumpeter's argument was about. He was saying that if that's the case, innovative companies will always come around. So we should be fueling this and That's the purpose of a financial system.

He's saying so let's say we have an entrepreneur who has ideas, but he doesn't have any money. And on the other hand, somewhere else, there was a capitalist, a guy with no ideas, but a lot of money. The purpose of the financial market is to bring those two together. So let's say we have an example where you have Thomas Edison, he has a company. He's got lots of products and inventions, and he doesn't have enough money to fuel this though. So someone else will come around like JP Morgan, and JP Morgan, will then buy shares in Thomas Edison's company to give him the money, he needs to invent some turn out all these products, and in return, JP Morgan will get paid back in dividends.

So, this where stocks essentially came about where you have stocks that were originally traded, actually in British coffee houses even had IPOs in these Victorian coffee houses, and shares came about, partly because investors wanted to take money out of the company. But sometimes the company didn't want to let go of their assets. So for example, let's say you had a supply company, and the company would ship off these goods to some other country. And once the goods were shipped, the investors just wanted to get their money back. And they were saying, hey, I want to sell the ships now. Because I invest the money in you to buy those ships and the products and you live with the products got the money now sell the ships, and the companies and I don't want to sell ships.

I want to keep the ships I want to keep doing business. So they went to the court and the judge essentially said, investors should just sell off their shares to some other investors. And that way, the company can keep their ships and the investors can collect their money. Prince Rupert came along and he realized that the North America has had lots of furs that could be sold for profit because first were in high demand at this time. So what he decided to do was raise money for the Hudson's Bay Company through shares. So he gathered a bunch of interest in this company and said, Hey, we're gonna go to North America.

There's lots of furs there. furs are selling like crazy here in Europe. Let's make a company. We'll fund it through shares, and then we will collect our money back through dividends. So this goes on for a while and the Hudson's Bay becomes a reasonably successful company. JOHN Churchill was the third governor of the Hudson Bay Company.

And he he raised the dividend two to three times. Each time he raised the dividend. Shareholders back in Europe became extremely excited because they were collecting more money. He's dividends. And so they wanted to buy more shares and more shares that they bought, the price of the stock went up because there was more demand for that stock. But what it turned out was that the Hudson's Bay committee members, what they were actually doing was quietly selling off their shares until the committee was empty.

And the way they'd been funding the dividend was that the company had actually been selling off their ships. They've been selling off their ships and assets to pay the dividend. They actually hadn't been making as much money as investors thought they had been. Rather they were just selling all of their assets without telling investors. So this turned out to be a limitation to Schumpeter's financial system on money flowing from capitalists, entrepreneurs and back. And this limitation was trust.

There had to be trust in order for the financial market to function. Without trust, someone could take the money and run either the entrepreneurial could take the money from the capital. list or whoever was funding the transaction between the capitalist and the entrepreneur and they could be taking money and running. So there had to be trust. And this is where we will lead into our next section is that trust relies on intellectual property rights.

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