For some business owners it is difficult to understand the types of financial systems and the role of financial system on their business. Here, we outline what you absolutely need to know for long-term money success…

Just how does the financial system affect your business?

Business leaders regularly interact with the financial system. In some ways, they need it to provide capital to cover their startup costs. And, without it, many entrepreneurs would have to wait years – perhaps decades – to bootstrap their companies and scale.

Surprisingly, only a small fraction of entrepreneurs know the financial system components and what makes it tick. People have strange notions of what a bank is and what banks are doing when they lend money. Even experienced business leaders can completely misunderstand what a central bank does, or how it controls the money supply.

These aren’t just academic topics. They affect the trajectory of the entire economy due to the filter-down effects they have on relative prices. When banks flex their financial muscle, it has a real impact on the economy, and the fortunes of millions of people hang on their whim. They are the true masters of the universe.

Business owners, therefore, need to learn about the context in which they operate. Banks aren’t just places that facilitate transactions. They also control the creation and flow of credit. That’s a big deal. 

Let’s take a closer look into two critical lessons business leaders should learn about the financial system functions.

The Financial System Is Inherently Unstable

Hyman Minsky was an academic who came up with something called the “financial instability hypothesis.” The idea is that the financial system is inherently unstable under the current regime, and no amount of tinkering around the edges can rescue it.

When banks lend out more than they have in reserve and financial speculators bet on assets, it automatically sets up an unstable situation. When it gets out of control, entire countries’ economies can fail, as happened in 2008 and 2009.

Knowing this is important for business leaders. They need to be prepared for system failure by hanging onto non-financial assets to support their activities during a major correction. If they don’t, they could see lines of credit dry up.

Banks Create Money Out Of Thin Air

What!?

If you thought the government created all the money in circulation, you’d be wrong. That’s not actually what happens at all. When entrepreneurs have money creation explained to them, hardly anyone can believe what happens or that it is even allowed.

When a depositor puts money in their account, the bank creates a promissory note. This note tells the customer that they can redeem the value on the note for cash whenever they like. The money, however, never exists in the account. Instead, banks display a “balance.” They lend out the money you deposit to other people, plus extra they create out of thin air, based on overall money demand.

This system is why runs on banks are possible. Banks never have all the cash they need to cover all their deposit withdrawals at once. So, again, business owners need to think carefully about their dependence on financial institutions.

Yes – banks survived the last crisis. But if there is a run on a bank, some depositors won’t get their money back. That’s because there never was any money in the first place — just promises from borrowers (usually mortgage holders) that they will pay the money they owe back.