Wise Economic Decisions (Importance of Personally Avoiding Recessions) Part 1

This is the 1st part in a 4 part series which discusses the ideas of recessions and there devastating effects.  It points out that well most peopleare destroyed in  these terrible recessions some people actually thrive and become exceedingly wealthy.  This paper tries to look at similarities between these entrepreneurs and hope to gain some insight from the past.  My hope is that the reader will find this series interesting and helpful.  If you have question, comments, or even suggestions on future topics please feel free to comment on the blog or email me on my Contact Me page. The works cited page will be included on the 4th part in this series:

It is estimated that the current recession has caused $45 trillion dollars globally in credit assets (Hammoudeh, 23).  Over 5.1 million jobs have been lost in just America and 8.5% of the population is currently unemployed (current recession stats).   This has been called one of the worst economic downturns since the great depression.  People have saved money their entire life and now, within months, their portfolio’s value has dropped to ten percent of its original worth.   America has seen companies that have been called the backbone of the industry, like GM or Chrysler, that are going bankrupt.  Huge banking giant Fanny Mae and Freddie Mac was completely destroyed and no longer exists.  This recession has completely changed people’s idea about the stock market and investing.  The worst part is that the recession still continues.  Some experts say that the recession has reached the bottom, but others say the worst is still to come.  Some predict unemployment will rise to at least 12% (Hammoudeh, 24) and the truth is that no one really knows for sure.

A recession is a terrible thing.  It can tear apart economies and destroy people’s wealth that they have worked their whole life to earn.  Economies usually bounce back and correct themselves but there are countless individuals who made bad economic choices and have become casualties of the recession and never recover.   One is faced with a decision that every person must face: what to do with fear, the fear of losing your money in the economic recession.  After the great depression, people were so scared by the stock market crash and the bank runs they vowed never to invest their money in the market or trust it to a bank (Mills, 143).  These people lived out the rest of their life putting their spare money in the corner of their mattress and sock drawer.  This is one way to try to avoid getting caught in a recession.  The problem is that throughout history money has generally inflated (Dewald, 16), so to save money is to have it slowly decrease in value.  Secondly, there is money to be made by investing your money.  People’s usual goal for saving their money is for retirement.  If they can wisely invest their money, they can retire sooner, so the incentive is there for people to risk their money in the hopes of gaining more.  But what about recessions and making mal-investments (Dewald, 16)?  A wise man named George Santayana once said, “Those who cannot learn from history are doomed to repeat it.” (George Santayana Quote)  This paper seeks to understand what causes the economic booms and busts in the markets and observes those who have managed to avoid getting sucked up in the boom and then flourish in the bust and learn from the wise entrepreneurs of the past.

It is important to understand how the market works before trying to learn a specific part of it like the boom bust cycle.  It is important to look at the whole picture.   In a perfectly free market, the market is not just a lump of capital bumbling around but highly complicated cycles of capital goods with alternative uses and interrelations.   There are some important qualities that are needed for the market to run successfully.  Most markets are not purely free markets, but they run with similar qualities as a perfectly free market, with slightly more restrictions in various part of the market (Serwer, 27).  The first quality that is needed is private ownership and the ability to buy and sell land.  People need to be able to own their labor.  If someone is not going to get paid for his work there is no reason for him to work or try and make any money because it would not be his money (hunter).   But if his labor is his own, and all the items he makes is his own, and he is free to make and sell it for money, then he has the incentive to make money.   The second quality is competition, there needs to be competition because without competition there is no reason to keep prices low.  The business would just raise the price as high as it was able to and the consumer would not be able to handle the price increase.  The third quality is that prices are set by the law of supply and demand, which means the price of a good is based on the quantity of that good and how much people actually want the good (Serwer, 27).   The fourth quality is consumer sovereignty.  This means that prices and profit are based on what the consumer wants and that business will make decisions based on its preferences.   The final quality is a profit motive.   First of all, companies need to be able to make a profit and be able to see a direct result between putting their resources in the market and making a profit.  If that happens, then companies will try and make as much money as possible, which happens by giving the consumer what he wants the most (hunter).

The market is an extremely complicated relationship of interconnected processes, so throwing money at it is highly unlikely to actually help it, but sometimes, for different reasons, business cycles go awry and the market goes into a boom bust cycle.  The boom bust cycle is a cluster of entrepreneurial mistakes (D’Amato).  In the normal cycle or market, there is a mix of good and bad entrepreneurs, but in a boom bust phase, almost everyone makes profits and then everyone loses money because of some strange occurrence in the market.  This wave of unexpected profit followed by loss always seems to follow a pattern. An example of this is the dot-com businesses in the 1990s and the housing and financial market now.  Since there is a capital structure, it not only affected the actual goods but all the steps and processes that goes into getting the goods.  An example is timber and dry wall for the housing market. When the housing market fell, the demand for dry wall fell too, because people did not need it as much since its main purpose was for building houses (D’Amato).   So there must be a reason that all these entrepreneurs made the same mistake.

One example is if we have certain regulations that cause there to be a moderate inflation of the money, and banks can only hold a fraction of their savings, so they can use unbacked money.  They can just create credit.   This will allow goods to become cheaper than they would normally be and make investors invest in things and go into debt when they usually would not.  As soon as a bank uses credit extension, it is now at the mercy of the consumer.  If the consumer no longer wants the goods, the company is now in financial stress because it has gotten itself into debt (D’Amato).   The problem is that this is not sustainable, and companies will eventually get caught in their debt.   The boom will turn to a bust.  Since the credit was really low, the capital structure was being built up, but people had not been saving their money to maintain the capital structure.  There is a conflict between people’s preference to save money and what amount of money is made available (Baumohl, 65).   A smaller proportion of money needs to be put toward the market, but because of credit expansion, the bad borrowed money goes into the money stream.  Just like all the other money, it can no longer be distinguished between actual money and the money that has been created by loans.

Consumers decide where they spend the money and the creditors create the money, but creditors cannot control the market.  Creditors keep printing and loaning money to keep the growing capital structure alive.  Something all of a sudden changes that causes the consumer to stop buying and spending the creditor’s money and the boom ends (Ebeling, 40-45).   The next part of the cycle is called the bust.  This is the period when the capital structure that got distorted during the boom has to correct itself to adjust for the actual demand without the policy or the credit expansion.  The demand for the good the company was making starts to go down and the prices need to be lowered so the companies stop making profits, and then they are not able to pay off their debt and the banks foreclose on them.  Businesses that might have survived without the boom fail, but because everything seemed so profitable they thought they should keep expanding.  They then went farther than they should have gone.   The capital structure has to shrink to adjust for the decreased demand (Ebeling, 64 – 72).  Goods built in the boom are still physical goods, things need to be redirected and redesigned to the proper capital structures.  Unfortunately, they are very specifically designed for the capital structure they were made for.  They can be changed and redesigned to make different stuff but the cost to convert them is very expensive and it will cost a lot of money.  Consequently, the goods are sold very cheaply.  Employees are laid off and have to find new jobs and learn new skills.