Coffee, dominos and the basics when understanding how the real economy functions.

Jun 29, 2020

Welcome to Finance and Fury. Today - Understanding domino effects within an economy –

1. This episode is aimed to help think more about orders of effect and consequences from actions –
2. Talked about this in last FF ep – this episode is a bit of a lighter episode – been talking about heavy theory for a while
   1. Purpose of this episode is to help explain the working of the real economy -
3. expanding on a thought experiment to help you understand the difference between government policies – that promise the best – but can deliver the worst –
4. It is fun to do and helps to expand thinking and understanding of the economy – and how we are the major driving factor behind the economy –
   1. how are we the driving force? It is based around our choices - and that what most policies do is just get in the way of choices -either directly or indirectly – and this can disrupt the economy from maximising itself – which is us making optimal choices
5. Every action has some consequences – good or bad
   1. Can happen everywhere – in nature – say there is a river – it gets diverted – then this floods somewhere else
   2. how policy can act as a diverting factor and always have consequences –

 

Most people are familiar with the concept of a consequence – to start with – think about your personal situation and consequences

1. In your Individual situation - this is relatively simple compared to consequences of policies - still complex the further you take the consequences of actions out – however – less variables in the individual situation
   1. Have to worry about opportunity costs to decisions –
   2. Looking at your own situation – actions have consequences – those that occur in the instant - But also long-term consequences – relative to your own environment –
2. Example - Change a household policy in financials – spend $20 less a week on coffee –
   1. That is the action – what are the consequences - In your own life you might be better off financially – may have less caffeine unless replaced with an alternative cheaper substitute
   2. Financially – the outcome is dependent on your action on what you do with the funds and over what timeframe – in one year you might save $1,040
      3. Pay $1,040 of mortgage off – would save an additional $20 in interest at 3.5% in first year
      4. Invest in something – wealth growth of $1,040 – might walk away $42 better off in the first year if it earnt 8% - total of $1,082

• What about over 20 years? Mortgage – paid off $20,800 of mortgage but saved $9,310 of interest – investing would be around $51,310 in total value better off

1. This is just one simple example – but you can do this for a lot of other actions that you take – even if you cant place a dollar value on it – like spending time with family -
2. Either way - Being aware of your own actions and consequences is an important first step –

Now let’s expand this out to the macro – that business has $20 less in revenues this week –

1. That is about $1,040 p.a. less for this company each year – this isn’t a major deal long term – if they are losing one customer – they can survive this –
   1. But expanding further –on average let’s say they have 200 customers each day – 25 per hour for 8 hours - Average customers/number of sales per week – 1,400 - average price of coffee is $5 – $7,000 revenue per week or $364k p.a.
   2. say that 60% of customers go – they are only earning $2,800 p.w. now – or $182k p.a. – doesn’t sound bad?
   3. Well - what about the costs - Wages per hour – major cost – rent as well – also inputs for making coffee
      1. Wages – Say 3 employees – each earning $25 per hour – minimum wage but with the casual loading - $600 per day in wages – assuming working for 8 hours
      2. Rent – say $25k p.a. so about $70 per day

• Product inputs – milk, coffee, cups – $1 per coffee in costs - $200 per day

1. Total costs p.a. = $240k costs at a minimum

1. What does a business have to do now – cut back on costs - The coffee shop would have to cut back on the purchase of these inputs – cut back on staff wages – has to find $60k of cutbacks to even break even – but even more for the business owner to make a living off
   1. But this also has its own flow on effects - which is less demand for those businesses who were selling coffee, cups, sugar, milk etc –
   2. Coffee company that produces and packages the coffee to sell to the shop– would have to buy coffee – have equipment and plants to roast and process – has employees – so has their own costs and revenues to worry about – same for the company selling milk – who gets this from farmers -

This is one relatively simple example of just one coffee shop and the flow on effects – to Help your personal understanding about the economy – and investing as well – as it helps to show which businesses may not fair so well when one industry is impacted heavily by policy

2. If anyone listened to the Episode a little while back on how we are the economy – this is relevant –
   1. Taking it a step further – the companies that supply this coffee shop – not a big deal if one of their customers has to cut back or goes out of busines –
      1. Similar to the individual ceasing buying coffee – it is just one of many they supply to – so to them it wouldn’t be a big impact
      2. Also – while it sucks for those few employees that now aren’t able to work or have reduced hours – there are other coffee shops to get work at -
   2. Say this happens industry wide – that is less for these supplier businesses on a massive scale –
      1. Those supplier business would likely lose large chunks of revenues - need to cut back on their own costs – this obviously has flow on effects of their own – at a large enough level – could put pressure on sub industries selling cups, so who supplies them would suffer as well – and so on
      2. Rental for café or pop up coffee shops – then there would be a major impact- so those who are the landlords for these businesses would suffer
   3. On the Government side – this is also less tax to collect – so lower revenues for them as well – could also be concerning to the economy - as they may have to raise additional taxes or can just get deficit money to cover expenses – but that is just more debt in the economy – which it has to try and soak up
3. See the nature of consequences here?
4. Larger point that this should be making - Our voluntary interactions with one another drive the economy –
   1. Our choices to purchase – drive business success
   2. Our choice on working – drive our own success – but also the ability to help drive the economy on many sides
      1. We are providing a service – working in a coffee shop or one of the businesses that supplies them their inputs – or in any field –
      2. Also generating an income that can be spent on other businesses – that through the chain effects of the economy – drive other companies

• Who then can employ more people to also complete this process

1. It is very complex- impossible to map out accurately -

5. When policy gets put into place that creates a disturbance to this – it has flow on effects to the economy
   1. Why it is unknown – and can have unintended consequences
   2. People or businesses will naturally try to survive – and when policy changes the very nature of an industry – any interconnected industry can be affected – and any industry that is connected to that can also be affected
   3. Same with the employees that work in any of those roles

Examples of domino effects – at the larger scale – especially when thinking about the recent shutdowns

1. Changes to the economy based around what is being said is the new normal –
2. Think about just part of the Retail sector – work wear – if you are only going to be shoulder up on zoom calls from home – will your dress habits change?
   1. Suit sellers – large retailers in the US like Brooks Brothers filing for bankruptcy
   2. Flow on effects – those that work in the stores and their incomes gone, the landlords, the people or companies that make the clothes – the companies that provide the goods to do so
      1. Machinery companies, dye companies, textiles like cotton, then those who grow the cotton – these are just a few as I am probably missing hundreds if not thousands of other affected parties

 

Now – think about large scale government or Central banking policies and interventions into the economy –

1. Market distortion and misallocation of resources on a grand scale – it is almost mindboggling when looking at the consequences of this to the whole economy
   1. As these sorts of policies do affect directly or indirectly everyone and every business within it
   2. Might not be directly noticeable in your daily life – beyond may your mortgage repayments going down –
   3. But similar to you deciding to spend $20 less at the coffee shop -
2. Cost of money goes down i.e. interest rate is just one – what about QE? Or the market misallocation now with SPVs?
3. This is why I have the view of less is more when it comes to policy
   1. It might sound good on paper – but it will have unintended unforeseen effects that can create a worse overall situation – talked about rental control and price controls in general never working out
   2. Creates a distortion between the real economy – us and our voluntary interaction – and destroys this – along with-it long term – that sector of the economy
   3. This is all just something to start thinking about – and if you are interested – start training your thinking about how the economy really functions – as opposed to what theoretical economists say based around a closed model based on assumptions that have no foundations in reality

 

Something to start in your own life if you think about it – that your actions do have consequences –

1. Planning for yourself long term – making sure you are making the right choices –
2. You cannot control monetary policy or Government policy – but you can control your choices to try and maximise your situation regardless of what is going on around you
3. Also – understanding these concepts Helps you not to get tricked by unicorn governance – train yourself to ignore bad promises
   1. If a politician promises something that sounds great – help to think about

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