Economic calculation is made possible by the invention of double entry bookkeeping accounting using units of medium of exchange as the common denominator. Economic calculation enables economic actors to plan over time production activities based on expected amounts of medium of exchange that can be received in trade for specified amounts of labor or land in the future.
The comparison of amounts of medium of exchange expended for land, labor and production functions compared to the amount of medium of exchange that can be obtained for the land, labor and production obtained from these expenditures allows for the calculation of a profit or loss on the proposed activity. A profit or loss indicates that a change is needed from the current allocation of land, labor and production functions. A profit indicates that the endeavor should be undertaken. A loss indicates that it should not be undertaken or that an existing activity should be reduced in scope.
The profit and loss tends to drive human activity to the state of an evenly rotating economy where any change from current activity would result in a loss. This evenly rotating economy in practice is never achieved because people change their desires, nature behaves unpredictably and innovations are creating production functions that combine land and labor in ways that more efficiently satisfy human needs.
Human activity has created the production processes that are in existence at any point in time. Those that do not show a loss for the present production period are considered ongoing businesses. The questions that need to be answered for these businesses for the next production period are:
Growth for growth's sake will not be profitable and is not what consumers need or require. This leads us to the standard economic concept of supply and demand curves.
Standard micro-economic text books contain reasonably clear explanations of supply curves and demand curves and how one maximizes profits. These explanations are interesting. From a practical point of view, the problem lies not in the supply calculation but in the demand calculations. Demand can be determined only by placing some goods or services on the market to see for what amount of medium of exchange they will be exchanged. To do this one has to speculate on the selling prices. The amount of medium of exchange needed to purchase land, labor and production functions is more easily determined since these items are already traded and usually current prices can be obtained.
The general concept that more supply brings lower prices and less supply brings higher prices is generally true; however, all goods and services have a finite demand. At some point everyone who wants the good or service has one. When this occurs the demand drops only to replacing items that wear out.
Planning how to allocate land, labor and production functions is a critical process necessary for the smooth functioning of economic activity. Planning for an ongoing business requires estimating demand for the product or service in the future exchange periods, the amount that can be produced in future production periods, competition and the profit to be obtained.
Two key planning tools are the balance statement and the income statement. These statements in various forms are used to evaluate the current success or failure of a production activity and estimate future results of various production plans. These tools will be examined from the economic point of view, not from a tax or subsidy standpoint. Taxes and subsidies, are in many cases, intended to subvert the underlying economic tendencies.
All production activity is derived from natural persons' consumption; therefore, the income and balance statements will be looked at from that perspective. The land and labor used in production is owned by natural persons ultimately even if the ownership passes through corporate persons.
The balance sheet is used to state in terms of medium of exchange the ownership of all the land and production functions controlled by an economic entity. In practice businesses treat these statements in various ways. To simplify, items owned or claims on others are called assets and claims on the entity by others are called liabilities. The difference is either net worth for a natural person or equity in terms of a corporate person.
From period to period, net worth or equity should be positive and not decrease. A negative net worth or equity indicates that bankruptcy is a serious possibility since promises to others can not be honored and assets are being depleted or more obligations are being taken on than can be supported by the assets. When one looks at assets the amount that represents the present value of the future income stream in terms of medium of exchange is what needs to be placed on the balance sheet to make the calculation sound, from an economic point of view. The value of a house tends to be determined by the present value of the future income stream that a future buyer is willing to dedicate to housing. For natural persons a simple balance sheet follows:
| Assets | Liabilities | Cash | Student Loans |
|---|---|
| Financial Instruments | Mortgages (house) |
| Real Property (house) | Secured Debt (car) |
| Transportation Equipment (car) | Unsecured Debt (credit cards) |
| Furniture/Fixtures | |
| Clothing | |
| Sinking Fund (replace worn out items) | |
| Net Present Value of future earnings | |
| ======== | ========== |
| Total Assets | Total Liabilities |
| Net Worth = Total Assets - Total Liabilities | |
Corporate persons tend in current practice to not be valued at the present value of future income streams (dividend payments) but by less rational reasons from an economic point of view. It is important to realize that subjective value, a key tenet of modern economics, means that something is worth what someone else is willing to exchange for it. Marketing hype or mistakes can cause exchange valuations to be vastly different from the present value of the expected dividend streams discounted by the interest rate over the expected lifetime of the corporate entity. The liquidation value would also be added.
The valuation of a company should be based on its expected earnings over the period of time it is expected to be viable plus whatever can be obtained from its liquidation.
Many companies such as restaurants may be viable and profitable for a few years but as tastes change they are no longer viable. An investment in them is sound. as long as the return over the period of viability is high enough and the restaurant is liquidated before it incurs losses.
Since balance sheets are snapshots of ownership at a point in time, a different financial calculation called an income statement is needed to analyze the transactions that take place over the period between balance sheets. Natural persons are the reason that there is economic activity so the analysis should start with their production and consumption. Natural persons' productive activities produce income in the terms of medium of exchange and their consumption produces expenses. A natural person by providing labor is the fundamental production actor. Land is the existing physical reality to which the labor can be applied.
A natural person's income and expenses could be categorized as follows in the list below. The categories of income and expenses are classified by their purpose, not by who provided the receipts or payments. This is a difference from the way many income statements are constructed but is done to illustrate the statement from the economic rather than the tax accounting point of view.
'Taxes' are paid for the provision of a variety of services and should be examined from the perspective of the value the individual service provides, not the type of organization that provides it.
A second analysis should be made as to whether the provider of the service; government, nonprofit or forprofit organization, is the most efficient provider of the service. This analysis must take into account the particular characteristics of the service, for example insurance.
Insurance needs to be examined relative to what is being insured such as house, car, life, medical expenses, general liability, etc. In many cases there are adverse selection and other tendencies which may make the category uninsurable in conventional forprofit markets.
In the expense categories for housing, transportation and furnishings there is an expense subcategory called 'Depreciation-Sinking Fund'. This subcategory is used to recognize that the items in the main category are items that have long, useful lives and are not consumed in one period like food. Resources need to be set aside to replace them when they wear out or become obsolete. These funds would be placed in the sinking fund on the balance sheet and used to offset the decline in the asset value due to depreciation. These funds would ultimately be used to replace the item or bring the item up to current standards.
Both the life span of the asset and the lifespan of the natural person need to be considered. Depreciation is the calculation used to asses the ability of the asset to perform its function over the next periods at a satisfactory level. The natural person needs to review if the sinking fund is necessary in light of the persons expected remaining life span and the ability of the item to provide the required service.
Life expectancy of the natural person making the economic calculation needs to be carefully considered. When the person is young the person's net worth is, in most cases, too low, because the present value of the person's earning power is not included. Presuming the person builds net worth as his or her life proceeds, the land part of net worth will reach a point where it can be large enough to support the person at a reasonable standard of living until death without having to continue to work. At this point, retirement can be considered. Over a person's life span they will see fluctuations in economic activity attributed to the business cycle. These fluctuations can result in severe impediments to a natural person's ability to build net worth and retire.
As discussed in the Medium of Exchange chapter of this work, the banking system causes cycles in business activity because of its ability to change the amount of medium of exchange very rapidly and transfer large sums of created medium of exchange to its favored interests through loans. These actions can have very deleterious effects on natural persons' net worth, even if they are careful.
The effect of these actions can be estimated using inflation rates. All other things considered constant, goods and services should fall in price due to increases in productivity as better techniques are discovered through innovation. However, due to the banking system's creation of medium of exchange, it is common to see prices over a lifetime increase 10 or more times. This makes it difficult to save for retirement since a dollar saved early in life is nearly worthless in retirement unless investment return can keep up with inflation of the medium of exchange. This is usually impossible because the creation of medium of exchange depresses interest rates by increasing the amount of medium of exchange available and depressing the relative value of a natural person's savings.
The business cycle also gives a false sense of wealth as extra medium of exchange is used to bid up the prices of assets such as houses. The housing market is a prime example of this effect.
The manmade items of real property deteriorate over time. A rough rule of thumb is that a building has approximately a 100 year lifespan before needing replacement or total rehabilitation. This assumes general maintenance is performed. If there were no inflation, then there would be a slow but steady drop in the value of the house until major renovation occurred. The renovation will bring the house back to current standards of room layout and amenities.
The house itself would not be a source of net worth increase in terms of purchasing power. It is a long-lived consumption good, not an investment that generates income. To make things worse, taxes are owed on the phantom capital gain brought about by the inflation caused by the banking system's increase in the amount of medium of exchange.
Similarly, investments in stocks are destabilized by the increase in medium of exchange. Loans to purchase stock inflate the sales price and devalue earning power as expressed in dividends as speculators seek to capture short term gains by trading the stock.
A common tactic used by investment funds is to search for companies with well funded pension systems, well maintained plant and equipment, adequate staff and low debt. The funds go to a bank with the following proposition: `Lend us the money to buy a controlling interest in the company. We will strip the pension fund of cash, reduce maintenance, research and development expenses, and fire staff (downsizing) and require the remainder to work unpaid overtime. The effects of the downsizing will scare the remaining workers to work extra hours and not ask for raises. We will divert the dividends and other cost savings to paying you interest and us a large fee.
If the company fails, it is put up for sale or liquidated. In any case, it is weakened. In this type of analysis, the aim is to extract as much money as possible without causing it to fail in the short run. The reduction in expenses will increase short term earnings and allow the fund to show that its actions made the company more profitable. It will allow them to unload the company before the effects of reduced maintenance, research and development and the exhaustion of the work force reduce its earning power.
Many sound companies have been damaged and many pension funds have been looted through this method. The method is greatly facilitated by the creation of medium of exchange through loans given to favored parties. This is why so much emphasis is given to networking the right people. If you have the right contacts you can get a loan at a very favorable interest rate funded by the federal reserve bank and you are bailed out when your loan fails.
Economic calculation most be done to plan for a comfortable life. Balance statements and income statements are the primary tools. The business cycle most be taken into account if investment decisions are to be sound.
Copyright 2014-2019 Richard A. Cornell, PE