who are willing to pay the whole value of the rent, wages and profit, which must be paid in order to bring it thither… The market price will sink…” - Adam Smith
“Look at your wealth as a loan. It can be called away at anytime.” - Peter Bernstein
With very few exceptions, the attainment and preservation of wealth is of primary concern to most adults. Although it is of great concern, very few people have put in even a minimal amount of time studying the foundation for how wealth is defined, attained and maintained. Without a practical understanding of how our economic system truly works it is nearly impossible to set a course that will allow you to maximize your profits and insulate yourself from losses. In today’s revolutionary and rapidly changing economic climate it is even more important than ever to grasp the foundation of our economic system because both profits and losses can and will happen at an accelerated pace.
I sure wish I had paid attention to economics when I was in high school. As far as my friends and I were concerned as long as we had enough money from our allowance and our part time jobs to buy the latest fashion, hang out and splurge on the latest gadgets, nothing else mattered. If you were that one kid in class that really paid attention, then some of this might just be a refresher for you. If you were like my buddies and I, then even as an adult you probably feel disconnected from the economy, un-influential in affecting it, and feel you are at the total mercy of a mysterious, outside force. Once you truly understand how our economy is designed, you will realize that nothing could be further from the truth. Each of us is a key player in the economy and every financial decision we make (spending, saving, investing, etc.) affects the economy.
Hang on while I put my teacher cap on and get really academic for a minute. We live in a free market economy which was developed from the evolution of the treaties, “An Inquiry Into the Nature and Causes of the Wealth of Nations,” written by Adam Smith, a Scottish economist and moral philosopher, in 1776 before there was a United States of America. This visionary work clearly laid out the principles necessary for a successful economic shift from a primarily agrarian based economy to an Industrial based economy. It proposed that a free market economy was more productive and more beneficial to society than any other form of economy.
A free market describes a market with no economic intervention and regulation by government except to regulate against force or fraud. A free market economy requires protection of property rights, but no regulation, no subsidization, no single monetary system and no governmental monopolies. The three major aspects that determine a Free Market Economy are that it allows competition domestically and open to trade with the rest of the world, it possesses institutions that make an economy work, and it has a judicial system that enforces the rights of ownership.
Stay with me, I know you might be getting a flash back to high school, but trust me this is leading somewhere. The theory holds that within the ideal free market, property rights are voluntarily exchanged at a price arranged solely by the mutual consent of sellers and buyers. By definition, buyers and sellers do not coerce each other, in the sense that they obtain each other’s property rights without the use of physical force, threat of physical force, or fraud, nor are they coerced by a third party (such as by government via transfer payments) and they engage in trade simply because they both consent and believe that what they are getting is worth more than or as much as what they give up.
Adam Smith’s writings can be summed up simply as wealth is determined by the value of assets you possess. The assets that create wealth can be categorized into three principal categories: personal property, including homes or automobiles; monetary savings, such as the accumulation of past income; and the capital wealth of income producing assets, including investments in real estate, stocks, and bonds.
The ascribed value of the assets is subjective and based upon the whims of the market. Value, therefore, is the result of buying and selling decisions en masse more commonly known as the law of supply and demand. As demand by the market goes up and the supply goes down, the value increases. Alternately, as the demand goes down and the supply goes up, the value decreases. As a result, wealth increases or decreases when values change. Wealth is therefore passive and transfers from one place to another as valued assets change hands.
Ninety percent of the world’s wealth is held by people in North America, Europe, and high-income Asian countries and a mere one percent of adults are estimated to hold forty percent of world wealth. However, we are currently witnessing the greatest transfer of wealth (valued assets) in US history. Our current recession has ignited a mass movement of wealth. Home values dropped from their peak in 2006 by thirty one percent in 2009. In most cases there was a complete loss of equity. 401(K) values have declined on average by fifty percent, and the US Dollar value continues to decline. Between 2002 and 2008, the US dollar lost forty percent of its value.
The good news is that, as stated above, wealth does not disappear. The wealth that left the hands of the average person (equity, retirement accounts, etc.) is hanging in limbo waiting for those with new ways of doing business in the 21st Century to grab it. When the market (which includes you) determines where the new value is, the wealth will follow. How you position yourself right now will determine whether you continue to lose or the wealth is transferred to you.
You must position yourself in such a way that you are not chasing behind obsolete and unprofitable financial vehicles. It does not make sense to dump money, time, energy or resources into an investment (securities, real estate) or a business that does not have the ability to create the income necessary for you to get the profit outcomes you desire. This means that you make all of your financial decisions (investments, business startups, etc.) based solely upon supply and demand by the market.
How Was This Economic Disaster Created?
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” - Alan Greenspan, 1966
“At the base, this is about excessive government credit, encouraging people to be greedy and excessive in their consumption and investments, masking risk (by not punishing risk sufficiently). We are, in a sense, being punished for our excesses, and we are reverting to the mean after past excesses.” - Adrian Day
The very nature of a free market economy dictates constant fluctuation in the market. This periodic fluctuation in market activity is based upon levels of employment, cost of goods and services, availability of low interest capital (credit, loans, mortgages, etc.), and levels of production. Inevitably, an economy reaches its full capacity, and, with little free capital and no new demand, the process reverses itself and contraction follows. Periods of prosperity (booms, bubbles) are eventually followed by economic crises (stock-market crashes, bankruptcies, unemployment, etc.). Some economists have identified recurring eight to ten year cycles in market economies.
The above information might seem intimidating, and by now you might be thinking you need to be a brilliant mathematician or economist to understand how to hang on to your life savings and build yourself a nest egg so you can retire. I promise that you will one hundred percent relate to and fully understand how the cycles of the economy work because in the most simplistic of terms, using recent events in our history, I will show you the rhythm of the economy and how people find themselves both influencing and influenced by the economy.
Greed and Fear Create Bubbles and Recessions
It is critical to realize that it is the emotional state of the players in the market (buyers and sellers) that create bubbles and their inevitable bursts. How did we get into such a quagmire with our economy? The simple answer is pure greed, but that wouldn’t adequately sum it up. The market is driven by two emotions; fear and greed. During boom times, greed or the prospect of making outrageous sums of money at little
