Why the “Bad Economy” is "Good" for Us

THOSE of you who have read my blog entries may not know that I am also a businessman.  I have a degree in Business Administration and ran a business for 30 years before becoming a computer scientist, where I am now.  I started business when I was only 16 and never had to ask for a job until I decided to contract my computer skills when I was 44.

            Educated and experienced people take a whole different approach when we hear of “bad” economic news.  I wish to share some knowledge with you.      

Part 1 of a Series on Economics

     Okay.  You know the story.  Bad stock market is bad for us, right?  People lost money when the stock goes down.   But if you took the same courses I took in my college days, when I majored in Business Administration, you would know that the media lies.

      Let me explain what stocks are.  They are pieces of paper which, by and large, mean you get money from the companies that issue them based upon how much the company profits in a year.   A stock is valuable when the return on the stock (how much you get on a yearly basis) is at least as good as if you invested your money in another thing.

       There is a complication to that, though.  The risk factor.  If you can get a very stable income from your money by keeping it in a savings account, you might get a very, very low interest rate (return on your money) of, perhaps, 5 percent.  (For each $100 you keep in your savings account you get paid $5.00 a year by the bank.)  However the bank lends money to businesses who invest in making their business grow.  This means the business makes a lot, the bank makes a little and you make a tiny amount.  The reason why the bank makes more is that they have to make a judgment as to who they lend to.  If they make a bad judgment, the person they lent their money to may not be able to pay them back so they suffer potential losses, or at least only a little profit on their investment after the business they lent to defaults on only some of their payments.  So, the greater the risk, the greater the interest a bank has to receive in order for you to justify lending the money to the business.

      This is why when you buy a stock you get better  returns on your money.  It is you taking the risk that the business will do well.  If you invest wisely you will get great return on your money.  If you invest poorly, you will lose money.

       Let’s examine this more carefully because this is where a lot of people get confused.  What is “investing wisely?”  It is when you make a judgment call.  Let’s see you have $10,000 to invest.  In the bank you could get, let’s say, 5% per year.  If you buy a bond you could get, maybe 12% because you are pretty much guaranteed of getting your money back unless the company gets into real trouble.  Bonds are stable.  The fact is, you buy a bond for your $10,000 and the company has to pay it back by giving you $11,000 at the end of one year.  Your return is guaranteed to be $1,000, unless the company goes bankrupt and can’t pay what they owe.  Pretty stable income compared to stocks.

            With stocks, the board of directors of the company (the decision makers) will make a business decision: How much of our profits will we set aside for our stockholders?”  They have to make the decision based upon a few factors.  First, how much money did they make that year?  How much should be invested in the infrastructure of the business so that their business will grow?  How much will they give to the stockholders?

            The reason they want to give as much as they can to their stockholders is that the more they pay out, the more value the stocks have.  People will pay more for the stock when it gives a better return on their money.  The judgment of the stock buyer has to include the estimation of whether or not the company issuing the stock will make money, lose money or go belly up and collapse.  If you buy stock when the dividend (the amount the company pays the stock holder for owning a share of its stock) represented a good rate of return, you’ll have paid a higher price for the stock.  But if you sense that the company won’t be able to continue to pay that amount and you expect the return on your money will be less in the future, then the stock will logically not be worth as much as it did and the price should fall.

            Bad decisions is when people lose money.   You invest your  $10,000 in a company by buying stocks and you don’t get as much as you thought you would because the company wasn’t as profitable as was expected to be.  You lose the amount of dividend that the company didn’t pay you due to smaller profits.

            Because the stock no longer pays as much dividend, your stock price falls.  Suddenly your $10,000 in stock is now worth only $8,000 because the dividends are now so small that there are better places to invest your money than that company.  You can decide to sell the stock and put that $8,000 that will give you the return rate that an investment of $8,000 merits.            

            So why is a collapse of the stock market bad?  Why is it good?  Consider this example from everyday life.

            You buy a new bicycle for $300 from the local store.  That’s the best price for it you found after careful shopping.  It is worth $300.  It is not worth $350 which the other store wants to sell it for because the price that one store sold it to you was $300.00 and that was the best price.  You were willing to pay that price.  That determines the bike’s worth.  This is called the Law of Supply and Demand which determines price in our capitalistic country.

            Let us say you come across a friend who likes your bike and loves it so much that he his willing to buy it from you at $500.00!   Wow!  What a fool.  He could get a better bike for his money but he didn’t know about that one store you bought it from.  He only knows about that store that wants to sell them for $550.00.  He thinks he is going to save himself $50.00 by buying it from you.  So you sell it to him.

            YOU MAKE $200 off of the deal!  That is what you pay off your bills with and you buy another bike for $300.  You win!  But when the friend finds out about the store that sells it for $300, he then, and only then, realizes he paid too much for the bike.   He thinks, “I lost $200.”  But WHEN did he lose it?  Did he lose it at the time he paid you?  Yes.  Did he lose it at the time he found out that the bike could have been gotten a better deal elsewhere?  NO!

            Therefore when someone sells you a stock that is really overpriced, you lose money at the time of the stock purchase and, just as importantly, the seller GAINS exactly the same amount!  The seller gets more riches to the exact same extent that the buyer loses money!  Exactly!

            There is one good difference.  The wiser one who has the $200 (you) can now invest more wisely in other things and the money will be better invested.  It is only the relative “fool” (less wise investor) that suffers.  The economy?  The economy is better off having the money in the hands of a  better investor who makes wiser decision.  That is why the stock market collapse makes no difference.  For every billion dollars one group loses, the billion dollars is in the hands of another group of wiser investors. 

            So why does this sometimes cause chaos and lots of people get burned?  The answer is not all that difficult to understand.  Sometimes a person wants to borrow money and he uses his stocks as collateral for the loan.  This means that the bank lends him money but requires that the borrower puts up something of value as a stake.  That means that if the borrower doesn’t pay off his loan, the bank keeps the stocks for themselves.  That is what “collateral” means.  You don’t pay and the bank keeps your stocks.

            So let’s say the bank sees that you have $10,000 in stock and accepts it as collateral.  This means that you can get a loan and pay a very low interest rate.  Why?  Because your collateral lessens the risk to the bank.  They know they will own your stock if you default on the loan.

            The trouble comes in when your $10,000 in stock is now worth only $8,000.  The bank asks you to “recollateralize” the loan.  You have to come up with another $2,000 or your loan is called and you have to pay it immediately.  If you don’t have that $2,000, you’re in deep doo doo.

            So the foolishness, here, is two fold.  First, you didn’t make sure you had enough to back up the loan you took out when you used your stock for collateral and you didn’t take into account that the stock could decrease in value.  Shame on you.  But double shame on the bank for using stock as collateral when they should know better.  For you to collateralize the loan using $10,000 worth of stock, they should have been very sure that you had the means of coming up with more cash if the stocks fail.  Bad decision on the bank’s part!  They did themselves in by not being cautious.  That’s when you could go bankrupt, if you can’t pay your bills.  That’s when the bank can get into trouble because they can’t pay their bills when you can’t pay them.  The dividends to their own stock holders falls so their stocks aren’t worth as much.

           

            So why do companies issue stocks?  To raise money for expansion.  Basically it is just like you taking out a loan to improve your income (like paying for education, for instance.)  But they aren’t taking out loans.  You own a stock so you own part of the company.  Your income from that stock should represent a percentage of the company’s profit.  You own a tiny bit of the company so you prosper or fail as the company prospers or fails.

            So, in summary, a “bad economy” just flushes out the fools who made bad investments.  All of the money, I MEAN ALL OF IT just transfers hands from one person to the other.  The other person being the one who made wiser decisions.  Ultimately the economy is more sound from the action and should make all investors wiser for the experience.

 

Part II:  A Second Reason why a Bad Economy is Good:

            Let’s look at things logically.   Because of bad decisions made by bad investors, 1,000,000 jobs are lost.  That means there are one million jobless people out there looking for jobs.   So there are more people out there who are vying for the existing jobs to be had.

            1: They will accept work for less payment.

            2: This means the employers can hire more of them.

            3: This means that with less money going to employees (labor cost is way down) the products they sell can sell for less.

            4: That means that you, the consumer of their goods or services, pay LESS for the product.

            5: That means your DOLLAR becomes worth more!  It buys more goods so it increases in value.

            6: That means that the employees who are receiving LESS for their services now have dollars that will buy MORE.

            It balances out.  Supply and demand is great for the economy because it all balances out.

            A stronger dollar means other countries will want to own dollars because they can buy more of our goods.  The existing dollars they have will be used to buy our products, thus increasing our production and sales.  The economy reaches a balance again.

 

Summary:        

            There are other reasons why the “bad” economy is “good” for us but it requires more sophisticated concepts too elaborate to describe in this one blog entry.  Suffice it to say that when you hear of a “black” day on Wall Street, you must remember that for every person who lost money in stocks, another person gained just as much.  While one person can’t pay his bills and loses his house, another person can pay his bills and buy his house.  It should be a neutral situation.  It is only when bankers accept too little for collateral that their decisions make deep, but temporary, bad wobbles in the economy.