Week in Review
Let’s imagine you buy your groceries a different way. Instead of going to the store and picking things off of the shelves and paying for them at checkout imagine this. You don’t pay the store. A third party does. Like it does for everyone else that shops at this store. Sounds great, doesn’t it? Let’s say people pool their money together for purchasing power. And have this third party take that pooled money and use it to get better pricing. Because of the large amounts they will be paying for.
So everyone pays in a monthly amount to their third-party purchaser. Then goes to the store and takes what they want. And at checkout they just sign an invoice to acknowledge they took this stuff. And the store will submit the bill to the third-party purchaser. Of course, there would have to be some rules. Because if everyone pays a flat amount each month you can’t have someone picking up steaks every day when you’re buying hamburger for your kids. So there are limits to what you can buy. Requiring the third party to review every submitted invoice. Requiring a very large staff to review every grocery store purchase to approve and disapprove line items on each and every invoice for payment. To resolve billing and payment errors. And to bill shoppers for any unapproved purchases they made. Even if they didn’t understand that these items weren’t covered.
So, included with that monthly payment there must be an overhead fee. To pay for all those people reviewing those invoices. Those who bill shoppers for unapproved items. Those who pay for the approved purchases. And those who process payments from shoppers. Still, things slip through the cracks. People are getting unapproved purchases through the system. Grocery prices rise. The overhead costs at the third party grow due to new costly regulations. Etc. Such that on occasion the total amount of cash out at the third party exceeds the total of cash in. Requiring them to raise the monthly amount everyone pays.
Sounds a bit more complicated than just going to the store and paying for what you want out of pocket. And more costly in the long run. But if someone else pays the third party for those monthly fees it’s a whole different story. Say as a benefit at work. Because without you having to pay anything it’s just free groceries. At least, to you. And you will demand that your employer pays for more stuff so it’s free to you. Even though it’s not. Because the rising cost of third party grocery purchases will cost your employer. Which will limit your pay. And other benefits. Because in the real world nothing is free. Even if people think that a lot of stuff is free. Or should be free. Like health care (see Nearly 7 in 10 Americans say health plans should cover birth control by Karen Kaplan posted 4/22/2014 on the Los Angeles Times).
Among the various provisions of the Affordable Care Act, few are as controversial as the one requiring health insurance providers to include coverage for contraception. A new survey finds that support for this rule is widespread, with 69% of Americans in favor of the mandate…
Women, African Americans, Latinos and parents living with children under the age of 18 had higher levels of support for mandatory contraception coverage than people in other demographic groups, the survey found…
— 85% of those surveyed supported mandatory coverage for mammograms and colonoscopies.
— 84% supported mandatory coverage for recommended vaccines.
— 82% were in favor of mandatory coverage for diabetes and cholesterol screening tests.
— 77% backed the provision on mandatory coverage for mental health care.
— 75% supported mandatory coverage of dental care, including routine cleanings.
There’s a reason why the United States is a republic and not a democracy. For the Founding Fathers feared a democracy. And wanted responsible people between the people and the treasury. For once people understood they could vote themselves the treasury they would. And things like this would happen. Mob rule. Where the mob demands more and more free stuff while fewer and fewer people pay for that ‘free’ stuff. And people in government anxious to win elections will keep giving the people more ‘free’ stuff that others have to pay for. Until one day you end up with the health care system we have in the United States. All because other people were paying for routine costs people could expect and budget for. Things that if they paid out of pocket for would cost less in the long run. Which would keep insurance what it was supposed to be. Insurance. And not turn it into a massive cost transfer scheme that only allowed the price of health care to soar.
Tags: Affordable Care Act, benefit, bill, contraception, democracy, Founding Fathers, free stuff, health insurance, insurance, invoice, Mob rule, overhead, payment, prices, routine costs, third party
The Benefit of a McDonald’s Franchise is getting the Benefit of their Years of Building their Brand
Recently a late-night comedy show attacked McDonald’s for being greedy. Because they don’t pay their minimum wage workers a living wage. Because what were once entry level jobs are now the primary support for some families. And why have entry level jobs come to support families? Because the anti-business policies of the current administration have destroyed better-paying jobs. But they don’t attack that on late-night television. They attack a company actually providing jobs in a jobless economy.
Today McDonald’s is huge. You can find them pretty much anywhere in the world. Which can be a welcome site for a weary traveler. For they know they can walk into a McDonald’s wherever they are and have the comfort of a meal exactly like that at home. Which is pretty amazing if you think about it. And why McDonald’s is so successful. The sight of those Golden Arches can attract a foreigner in a strange land or a construction worker on a new project in a distant city. They know exactly what they can get at that McDonald’s. What it will taste like. And what it will cost. Even if they’ve never been in that McDonald’s before.
This is because McDonald’s has very successfully built their brand. Which is one of those intangible things. It has great value. But you can’t physically touch it. Those who own a McDonald’s franchise can enjoy a thriving business. From day one. Without doing any marketing to get people to walk into their restaurant. They don’t have to. Because McDonald’s has already done it. And continues to do it. This is the benefit of the franchise. You get the benefit of all those years of hard work McDonald’s did to build their brand by simply paying a franchise fee (see Restaurants and Franchises posted 8/5/2013 on Pithocrates). It’s not cheap. But it’s such a fair deal for both franchiser and franchisee that McDonald’s had 27,882 franchised stores in 2012 (see McDonald’s 2012 Annual Report, page 11).
Owning a McDonald’s Franchise allows you to own a Restaurant that has been Successfully in Business for 72 Years
In addition to the intangible value of the brand the franchise fee also includes rent. For McDonald’s “owns the land and building or secures long-term leases” for the franchisee’s store (see McDonald’s 2012 Annual Report, page 11). While the franchise needs to foot the bill for the “equipment, signs, seating and décor.” This makes sure all stores are modern and up to date and uniform. Helping to maintain that comfortable familiarity for the customers. While splitting the capital costs between the franchisee and franchiser. So both parties have a major investment in the business. And each shares in the profits of the business. Perhaps the best of the deal for the franchisee is getting a mentor. And a detailed operating manual telling them everything they need to know and do.
Owning a McDonald’s franchise is costly. But you get to step into a restaurant that has been successfully in business for 72 years. Give or take. Considering that half of all restaurants fail within the first five years of business this is a HUGE benefit for the franchisee. And something well worth the franchise fee. As evidenced by 27,882 franchised stores in 2012. So what is that franchise fee? And how much money does the franchisee get to keep after paying the franchise fee?
Well, if you do a little number crunching with the financials included in the 2012 annual report you can get an approximate number. McDonald’s also has stores they own and operate. In 2012 they had 6,598 company-owned stores. The average per store revenue was $1,358,594 (calculated by dividing the total revenue from the company-owned stores by the number of company-owned stores). A similar calculation gives an approximate $667,205 franchise fee per franchised store. Subtracting the typical franchisee fee from the typical store revenue (assuming all stores have the same average revenue as the company-owned stores) gives the franchisee an annual income of $691,389. From this income the franchisee has to pay for food, labor and overhead. And whatever is left over is profit.
High School Kids and College Students work at McDonald’s because they need no prior Restaurant Experience
The rule of thumb in restaurants is that costs are broken down into thirds. One third is food cost. One third is labor cost. And one third is overhead and profit. So if we divide that $691,389 by 3 we get an annual food cost per franchised store of $230,463. Ditto for labor. And overhead (gas, electric, water, insurances, taxes, licenses, fees, waste disposal, light bulbs, toilet paper, soap, garbage bags, etc.) and profit. Let’s look at the labor cost more closely. To see if McDonald’s is greedy when it comes to paying their employees.
The benefit of owning a franchise is that it comes with very explicit instructions. A McDonald’s distributor delivers prepared food ready for the grill and fryer. As delicious as it is, though, it doesn’t take a highly skilled chef to prepare it. As the franchisee operating manual has it down to a science. Which is why high school kids and college students work at McDonald’s. They need no prior restaurant experience as it is an entry level job. Typically their first job. Where they learn what it’s like entering the workforce. The importance of being on time. Following instructions. Being responsible. Skills that they will use in later jobs. Which most do. As there is a high turnover of employees at McDonald’s as there is for all fast food. Because these are entry level jobs for unskilled workers. Who learn the skills they need on the job. So let’s assume a restaurant that is open 24 hours a day, 7 days a week. Assuming an hourly rate of $8.50 and an overhead of 40% for direct labor costs (workers’ compensation insurance, unemployment taxes, health insurance, uniforms, training, etc.) the average hourly labor cost comes to $11.90. Dividing the labor cost of $230,463 by this hourly cost gives us 15,758 annual labor hours. Or about 53.06 hours per day. Or 17.69 hours per 8-hour shift. Giving us an average of 2.21 workers per 8-hour shift.
During the breakfast and lunch rush a typical McDonald’s may have between 5-8 people working. With fewer working in the evening. And a skeleton crew over night working the drive-thru. So the labor fluctuates during the day to correspond to the amount of business. Which is why there are a lot of part-time workers at McDonald’s. Ideal for high school and college kids. In addition the owner typically works during those busy periods to help with the rush. And works on paperwork during the slower times. Putting in about 12 hours a day. If you assume an overhead rate of 18% and multiply that to the franchisee annual income of $691,389 we get an overhead expense of $124,450. Subtracting that from the $230,463 (overhead & profit) leaves an annual owner income of $106,013. Or, based on a work week of 84 hours (12 hours a day X 7 days a week), the owner earns about $24.27 an hour. A rate a lot of people can earn working for someone else without the headaches of owning a business.
That late-night comedy show attacked McDonald’s for being greedy. Saying they should increase their pay rate to a living rate. Like picketers were asking for. $15/hour. A labor cost increase of 82.6%. Or an additional $190,382 each year. Which would bring the franchisee’s annual income from $106,013 to an annual loss of $84,369. So are these McDonald’s franchisees greedy because they refuse to pay a living wage? No. They simply can’t afford to pay more than the minimum wage for these minimum wage jobs. Unless they can get people to spend $6-$7 for a Big Mac. They are delicious. But are they $6-$7 delicious? And can a low-income family afford to take the family to McDonald’s when they are charging $6-$7 per burger? Probably not. No. McDonald’s is just fine. What we need to do is to un-do the anti-business policies of this administration that is killing those higher-paying jobs. And forcing the primary earner in some families to work a minimum wage job. Because that’s all that is available in this jobless economy.
Tags: anti-business policies, benefit, Big Mac, brand, college students, entry level jobs, food, franchise, franchise fee, franchisee, franchiser, high school kids, income, intangible, intangible value, jobless economy, jobs, labor, labor cost, living wage, McDonald's, McDonald's franchise, minimum wage, minimum wage jobs, minimum wage workers, operating manual, overhead, profit, restaurant, revenue, value
Entrepreneurs have an Insatiable Desire to Think and Create
It takes money to make money. For it is money that buys the means of production. The land, manufacturing plants, small shops, office space, machines, equipment and infrastructure that make things. The trucks, barges, container ships, locomotives and rolling stock that transport raw material, work-in-progress and finished goods. These physical assets are capital. From assembly lines to inventory control systems to accounting software. Things that let businesses conduct business. And make profits.
This is the key to capitalism. Profits. It’s what allows businesses to make the things we need and enjoy. Profits are what make an entrepreneur take a risk. To spend their life savings. To mortgage their home. To borrow from a bank. They do these things because they believe they will be able to earn enough profits to replenish their life savings. To make their mortgage payments. To repay their loans. AND to earn a living in the process. It is a risky endeavor. And far more risky than working for someone and earning a steady paycheck. But if entrepreneurs didn’t take these risks we wouldn’t have things like the iPhone or the automobile or the airplane. All of which were brought to us because one person had an idea. And then invested in the capital to bring that idea to market.
Some business ideas succeed. Many more fail. But people keep trying. Because of that insatiable desire to think and create. And the ability to earn profits to pay for their ideas. To build on their ideas. To expand their ideas. From the first thoughts of it they kicked around in their head. To the multinational corporations their ideas grew into. All made possible by the profits they earned. The more they earned the more they could do. As they reinvested those earnings into their businesses. To buy more capital. That allowed them to build more things. And use even more capital to bring these things to market. Creating jobs all along the way. Jobs that only came into being because of those profits that started as a single thought in someone’s head.
If you can’t Service your Debt your Creditors can and will Force you into Bankruptcy
This is where corporations come from. From a single thought. Profitable business operations grow that thought into the corporations they become. For corporations are not the evil spawn of the damned. Corporations come from people having a great idea. Like Starbucks. And Ben and Jerry’s. Who are now everywhere so we can enjoy their products wherever we are. All made possible by the profits of capitalism.
Who’s up for a little accounting? You are? Well, then, you came to the right place. For we’re going to learn a little accounting. Right here. Right now. Corporations determine their profits by closing their books at the end of an accounting period. A series of accounting steps culminate in the trial balance. Where the sum of all debits equal the sum of all credits. Or eventually do after various adjusting entries. Once they do the books are balanced. And business at last can see if they were profitable. By producing an income statement. Which lists revenue at the top. Then sums all costs (materials, production wages, payroll taxes & health insurance for that labor, etc.) that produced that revenue. Subtracting these costs from revenue gives you gross profit. Then comes overhead costs. Fixed costs. Like rent and utilities. And overhead labor (corporate officers, management, accounting, human resources, etc.). They sum these and subtract them from gross profit. Which brings us to earnings before interest and taxes (EBIT). A very important profitability number. For if there is any money left by the time you reach EBIT your business operations were profitable. Your business was able to pay all the due bills to produce your revenue. Which leaves just two numbers. Interest they owe on their loans. And income taxes.
EBIT is a very important number. For if it’s not large enough to service your debt everything above EBIT is for naught. Because if you can’t service your debt your creditors can and will force you into bankruptcy. Never a good thing. And what follows is usually the opposite of growing your business. Shrinking your business. By seriously cutting costs (i.e., massive layoffs). And eliminating unprofitable lines of revenue. Downsizing and reorganizing as necessary so your cost structure can produce a profit at the given market price for your goods and/or services. A price determined by your competition in the market. If you cannot downsize and reorganize sufficiently to become profitable then you go out of business. Or you sell the business to someone who can make a profit. Because unless you can turn a profit your business will consume money. And that money has to come from somewhere. Typically it is the business owner until they run out of life savings and home to mortgage. Because a bank can’t give you money to lose in your business. For their depositors put their money into the bank to grow their savings. Not to shrink them. So a bank has to be profitable to please their depositors. And if the bank is using their money to make bad loans they will remove their money. As will other depositors. Perhaps creating a run on the bank. And causing the bank to fail. So while operating at a loss will save employees jobs in the short term it will cause far greater harm in the long term. Which isn’t good for anyone.
Capitalism works because with Risk there’s Reward
As you can see getting those accounting reports to fairly state the profitability of a business is crucial. For it’s the only way a business knows if it can pay its bills. And the way they pay their bills complicate matters. Revenue and costs come in at different times. To bring order to this chaos businesses use accrual accounting. Which includes two very important rules. To record accurately when revenue is revenue (for example, a down payment is not revenue. It’s a liability a business owes the customer until the sale transaction is complete). And to match costs to revenue. Meaning that every cost a business incurred producing a sale is matched to that sale. Even long-term fixed assets like buildings and machinery. Which they depreciate over the life of the asset. Charging a depreciation expense each accounting period until the asset is fully depreciated.
Because of these accounting reports that fairly state business operations a business knows if they are profitable. That they can pay all of their bills. Their suppliers AND their employees. Their health insurance AND their payroll taxes. The interest on their debt AND their income taxes. They can pay all of these when they come due. And not run out of money when other bills come due. Which is why they can have confidence when they read their income statement. Knowing that they paid all their costs due in that accounting period. Including the interest on their debt. And their income taxes. Which takes them to the bottom line. Net profit. And if it’s positive they have money to reinvest into their business. To expand operations. To increase sales revenue. Create more jobs. And they can grow. But not too much that they lose control. So they can always pay their bills. So they can keep doing what they love. Thinking. And bringing new ideas to market.
This is capitalism. Where people take risks. In hopes of making profits. They invest in capital to make those profits. And then use those profits to invest in capital. It works because there is a direct relationship between risk and profits. It’s why people take risks. Create jobs. And provide the things we need and enjoy. Because with risk there’s reward. And accounting reports that fairly state business operations give a business’ management the tools to be profitable. By matching costs to revenue. Telling them when they are not using their capital efficiently. Helping them to stay profitable. (Unlike anything the government runs. Because there is no matching of costs to revenue. Taxes come into the treasury and the treasury pays for a multitude of things. With no way to know if they are using those taxes efficiently). And this is capitalism. Risk and reward. And accountability. For when you’re risking your money you become very accountable. Which is why capitalism works . And government-run entities don’t.
Tags: accounting, accounting period, accounting reports, assets, bank, Bankruptcy, borrow, bottom line, buildings, Business, business operations, capital, capitalism, corporation, costs, create, creditor, debt, depositors, depreciate, downsizing, earnings, EBIT, entrepreneur, fixed assets, goods, gross profit, idea, income statement, income taxes, jobs, life savings, loans, machinery, market, match costs to revenue, money, mortgage, net profit, overhead, profitable, profits, reorganizing, revenue, savings, service your debt, services, think
When you have a Captive Audience you can Charge whatever Prices you Want
Go to a football game lately? Hockey? Basketball? Baseball? It’s a pretty expensive day out. Especially if you eat while in the stadium. Those concession prices are pretty steep. In fact, people say that stadium food is some of the most expensive food anywhere. I don’t. I say it is some of the highest quality and some the most fairly priced food you’ll find anywhere…in the stadium.
Stadium food is convenient food. And that’s what you’re paying for. Convenience. Because it’s too great of an inconvenience to leave the stadium to buy a more reasonably priced hotdog someplace else. And despite what the critics say of concession pricing, those concessions have long lines. Because people may say the prices are too high. But deep down they know what a bargain they are. Delicious food cooked and sold only steps away from their seat. It’s better than at home. And there’s no cleanup.
When you have a captive audience you can pretty much charge what you want. Because the market is fixed. Stadiums charge a fortune for those concession spaces. Because running a big stadium is expensive. And it’s not really used all that often. I mean, there are only 8 home games in the regular season in football. Doesn’t give the stadiums much time to earn revenue to pay for these expensive things. So they charge high fees wherever they can. So the concessioners have to pass that cost on to the customer. As all businesses do. And when you have a captive audience it’s a whole lot easier to do this. Because, where else are the people going to go?
Competition Increases Quality and Lowers Prices for Consumers
Let’s look at this in another way. Say you have a friend who works for a catering company. He drives a ‘roach coach’. He stops at the factories and local construction site to sell food to hungry workers. He sees the money these trucks make. Considers his paycheck. And thinks he’s tired of making his boss rich. So he buys a truck for himself. And looks for his own territory.
Now let’s say you go on an evening bike ride on weekends. And you come across your friend. He’s found some prime real estate to park his roach coach on. In the median of a boulevard across from an automobile assembly plant gate. Where he has a captive audience. Hungry workers working the midnight shift with no place else to buy delicious food. Business is good. You stop by on your bike ride and buy a snack and chat. Then one night you noticed a beat up Ford Pinto pull up in the median not far from your friend’s truck. He pops the hatch. And you start smelling something. Something good. Fresh pizzas. And hot fresh subs. This guy owns a pizzeria. And just closed for the night. After filling his car with fresh pizzas, hot fresh subs and soda. And just like that business wasn’t so good for your friend anymore. For fresh pizza and hot fresh subs are more delicious than the sandwiches and cans of stew your friend was selling. But one thing the Pinto didn’t have that your friend did. Ice. He was selling warm soda. Or trying to. Your friend had cold soda. And that was just what the doctor ordered on a hot, humid, summer night. Your friend was now sharing his captive audience. Selling less than he was. And at lower prices because of this new competition. But he was still able to turn a profit and make his truck payment.
Then the Pinto guy took it up a notch. One night, as the workers headed out into the median on break, he pulled out a tub filled with ice. And soda. “Cold soda,” he barked. “Ice cold soda.” This squeezed your friend’s sales even more. He had nothing left to compete with but price. So he lowered his prices even further. Barely breaking even. Then one night someone else pulled up on the median. A beat up AMC Gremlin. Some kid just out of high school got out. Popped the hatch. And started barking, “Fresh McDonald Big Macs. French fries.” And, of course, ice cold soda. The kid didn’t have a lot. But what he had he was selling at a nice markup. Which was enough for him. Because he had no overhead. And made enough to by some beer later that night. A very modest sales goal. But it split that captive audience three ways. Soon your friend was losing money. Then the economy went into recession. And they discontinued the midnight shift. Your friend lost his truck. And went back to driving a truck for his former boss. The Pinto guy increased his pizzeria’s delivery radius to make up for the loss business. And hired the Gremlin kid to help with those deliveries.
The Business Cycle is a Natural and Necessary Part of the Economy and is the Only Way Supply adjusts to Demand
From the perspective of the workers increasing competition made things better. Competition gave them more variety. Higher quality. And lower prices. Over time that competition gave them more value for their money. This microcosm of the economy was booming for awhile. Others jumped in. Making investments. Increasing their inventories. But eventually they expanded too much. Supply exceeded demand. Some inventory went unsold. Prepared food not being something you can return these people had no choice but to cut their prices. To reduce those burgeoning inventories. The guy with the highest overhead, your friend with the catering truck, was the first to fail. Then the market collapsed completely with the elimination of the midnight shift. So the other two had to shutter their operations there.
We call this the business cycle. It’s the boom-bust cycle of the economy. From good economic times (boom) to recessions (bust). It’s the natural ebb and flow of economic exchange. When the market presents a demand to be met supply flows into it. At first prices and profits are high. Like at a stadium with a captive audience. Then competition moves in. Unlike at a stadium. That demand is now split between the competition. Each sells less. And profits less. To try and increase sales they try to offer better value for the money. Tastier food. Colder soda. Etc. When that doesn’t work any longer they start lowering prices. But because supply built up so much as eager competitors joined in get a piece of that action supply grew so much it exceeded demand. And no amount of price cutting can fix that. Only a recession. To reset prices and supply to meet market demand. Which means some businesses fail. Those who don’t lay off employees. To reset their prices and production to levels that meets demand.
Monetary and fiscal policy tries to massage this business cycle. By softening the recession part of it. By lowering interest rates. To encourage businesses to invest and expand production. And hire more employees. Or by increasing government spending. Creating jobs by building roads and bridges. Or by simply giving more money to consumers (via tax cuts or stimulus checks) to encourage them to buy more. Thus encouraging businesses to hire more workers. To meet this ‘higher’ demand. Of course, in our example, this wouldn’t have helped our three businesses. None of them would have borrowed cheap money to increase supply. Not when supply already exceeded demand. In fact no amount of monetary or fiscal policy action would have helped. It certainly wouldn’t have added back that midnight shift. Unless the government started buying cars for people. Which might have put people back to work on that midnight shift. But such an expansion of government spending would have increased taxes. So high that it would have reduced economic activity elsewhere. As it transferred this money out of the private sector and into the public sector. Saving a few jobs at the cost of consumers everywhere paying higher taxes.
The business cycle is a natural and necessary part of the economy. It’s how supply adjusts to demand. And the only way supply adjusts to demand. Thanks to prices. That automatic mechanism that tells businesses exactly where supply should be. And by interfering with this you make markets operate blindly. Unable to know when supply exceeds demand. So supply keeps increasing even after it already exceeds demand. Creating bubbles. And when the bubble bursts prices plummet. To unload those burgeoning inventories. Making recessions longer and more painful than they need be.
Tags: boom-bust cycle, bubble, Business, business cycle, businesses, captive audience, competition, concession prices, Consumers, demand, economy, fiscal policy, government spending, higher quality, higher taxes, interest rates, inventories, inventory, jobs, lower prices, market, monetary policy, overhead, prices, profit, quality, recession, roach coach, selling, stadium food, supply, taxes, value, workers
DURING UNCERTAIN ECONOMIC times, people act differently. If business is down where you work, your company may start laying off people. Your friends and co-workers. Even you. If there is a round of layoffs and you survive, you should feel good but don’t. Because it could have been you. And very well can be you. Next time. Within a year. In the next few months. Any time. You just don’t know. And it isn’t a good feeling.
So, should this be you, what do you do? Run up those credit cards? By a new car? Go on a vacation? Take out a home equity loan to pay for new windows? To remodel the kitchen? Buy a hot tub? Or do you cut back on your spending and start hoarding cash? Just in case. Because those unemployment payments may not be enough to pay for your house payment, your property taxes, your car payment, your insurances, your utilities, your groceries, your cable bill, etc. And another loan payment won’t help. So, no. You don’t run up those credit cards. Buy that car. You don’t go on vacation. And you don’t take that home equity loan. Instead, you hunker down. Sacrifice. Ride it out. Prepare for the worse. Hoard your cash. Enough to carry you through a few months of unemployment. And shred those pre-approved credit card offers. Even at those ridiculously low, introductory interest rates.
To help hammer home this point, you think of your friends who lost their jobs. Who are behind on their mortgages. Who are in foreclosure. Whose financial hardships are stressing them out to no ends. Suffering depression. Harassed by collection agencies. Feeling helpless. Not knowing what to do because their financial problems are just so great. About to lose everything they’ve worked for. No. You will not be in their position. If you can help it. If it’s not already too late.
AND SO IT is with businesses. People who run businesses are, after all, people. Just like you. During uncertain economic times, they, too, hunker down. When sales go down, they have less cash to pay for the cost of those sales. As well as the overhead. And their customers are having the same problems. So they pay their bills slower. Trying to hoard cash. Receivables grow from 30 to 45 to 90 days. So you delay paying as many of your bills as possible. Trying to hoard cash. But try as you might, your working capital is rapidly disappearing. Manufacturers see their inventories swell. And storing and protecting these inventories costs money. Soon they must cut back on production. Lay off people. Idle machinery. Most of which was financed by debt. Which you still have to service. Or you sell some of those now nonproductive assets. So you can retire some of that debt. But cost cutting can only take you so far. And if you cut too much, what are you going to do when the economy turns around? If it turns around?
You can borrow money. But what good is that going to do? Add debt, for one. Which won’t help much. You might be able to pay some bills, but you still have to pay back that borrowed money. And you need sales revenue for that. If you think this is only a momentary downturn and sales will return, you could borrow and feel somewhat confidant that you’ll be able to repay your loan. But you don’t have the sales now. And the future doesn’t look bright. Your customers are all going through what you’re going through. Not a confidence builder. So you’re reluctant to borrow. Unless you really, really have to. And if you really, really have to, it’s probably because you’re in some really, really bad financial trouble. Just what a banker wants to see in a prospective borrower.
Well, not really. In fact, it’s the exact opposite. A banker will want to avoid you as if you had the plague. Besides, the banks are in the same economy as you are. They have their finger on the pulse of the economy. They know how bad things really are. Some of their customers are paying slowly. A bad omen of things to come. Which is making them really, really nervous. And really, really reluctant to make new loans. They, too, want to hoard cash. Because in bad economic times, people default on loans. Enough of them default and the bank will have to scramble to sell securities, recall loans and/or borrow money themselves to meet the demands of their depositors. And if their timing is off, if the depositors demand more of their money then they have on hand, the bank will fail. And all the money they created via fractional reserve banking will disappear. Making money even scarcer and harder to borrow. You see, banking people are, after all, just people. And like you, and the business people they serve, they, too, hunker down during bad economic times. Hoping to ride out the bad times. And to survive. With a minimum of carnage.
For these reasons, businesses and bankers hoard cash during uncertain economic times. For if there is one thing that spooks businesses and banks more than too much debt it’s uncertainty. Uncertainty about when a recession will end. Uncertainty about the cost of healthcare. Uncertainty about changes to the tax code. Uncertainty about new government regulations. Uncertainty about new government mandates. Uncertainty about retroactive tax changes. Uncertainty about previous tax cuts that they may repeal. Uncertainty about monetary policy. Uncertainty about fiscal policy. All these uncertainties can result with large, unexpected cash expenditures at some time in the not so distant future. Or severely reduce the purchasing power of their customers. When this uncertainty is high during bad economic times, businesses typically circle the wagons. Hoard more cash. Go into survival mode. Hold the line. And one thing they do NOT do is add additional debt.
DEBT IS A funny thing. You can lay off people. You can cut benefits. You can sell assets for cash. You can sell assets and lease them back (to get rid of the debt while keeping the use of the asset). You can factor your receivables (sell your receivables at a discount to a 3rd party to collect). You can do a lot of things with your assets and costs. But that debt is still there. As are those interest payments. Until you pay it off. Or file bankruptcy. And if you default on that debt, good luck. Because you’ll need it. You may be dependent on profitable operations for the indefinite future as few will want to loan to a debt defaulter.
Profitable operations. Yes, that’s the key to success. So how do you get it? Profitable operations? From sales revenue. Sales are everything. Have enough of them and there’s no problem you can’t solve. Cash may be king, but sales are the life blood pumping through the king’s body. Sales give business life. Cash is important but it is finite. You spend it and it’s gone. If you don’t replenish it, you can’t spend anymore. And that’s what sales do. It gets you profitable operations. Which replenishes your cash. Which lets you pay your bills. And service your debt.
And this is what government doesn’t understand. When it comes to business and the economy, they think it’s all about the cash. That it doesn’t have anything to do with the horrible things they’re doing with fiscal policy. The tax and spend stuff. When they kill an economy with their oppressive tax and regulatory policies, they think “Hmmm. Interest rates must be too high.” Because their tax and spending sure couldn’t have crashed the economy. That stuff is stimulative. Because their god said so. And that god is, of course, John Maynard Keynes. And his demand-side Keynesian economic policies. If it were possible, those in government would have sex with these economic policies. Why? Because they empower government. It gives government control over the economy. And us.
And that control extends to monetary policy. Control of the money supply and interest rates. The theory goes that you stimulate economic activity by making money easier to borrow. So businesses borrow more. Create more jobs. Which creates more tax receipts. Which the government can spend. It’s like a magical elixir. Interest rates. Cheap money. Just keep interest rates low and money cheap and plentiful and business will do what it is that they do. They don’t understand that part. And they don’t care. They just know that it brings in more tax money for them to spend. And they really like that part. The spending. Sure, it can be inflationary, but what’s a little inflation in the quest for ‘full employment’? Especially when it gives you money and power? And a permanent underclass who is now dependent on your spending. Whose vote you can always count on. And when the economy tanks a little, all you need is a little more of that magical elixir. And it will make everything all better. So you can spend some more.
But it doesn’t work in practice. At least, it hasn’t yet. Because the economy is more than monetary policy. Yes, cash is important. But making money cheaper to borrow doesn’t mean people will borrow money. Homeowners may borrow ‘cheap’ money to refinance higher-interest mortgages, but they aren’t going to take on additional debt to spend more. Not until they feel secure in their jobs. Likewise, businesses may borrow ‘cheap’ money to refinance higher-interest debt. But they are not going to add additional debt to expand production. Not until they see some stability in the market and stronger sales. A more favorable tax and regulatory environment. That is, a favorable business climate. And until they do, they won’t create new jobs. No matter how cheap money is to borrow. They’ll dig in. Hold the line. And try to survive until better times.
NOT ONLY WILL people and businesses be reluctant to borrow, so will banks be reluctant to lend. Especially with a lot of businesses out there looking a little ‘iffy’ who may still default on their loans. Instead, they’ll beef up their reserves. Instead of lending, they’ll buy liquid financial assets. Sit on cash. Earn less. Just in case. Dig in. Hold the line. And try to survive until better times.
Of course, the Keynesians don’t factor these things into their little formulae and models. They just stamp their feet and pout. They’ve done their part. Now it’s up to the greedy bankers and businessmen to do theirs. To engage in lending. To create jobs. To build things. That no one is buying. Because no one is confident in keeping their job. Because the business climate is still poor. Despite there being cheap money to borrow.
The problem with Keynesians, of course, is that they don’t understand business. They’re macroeconomists. They trade in theory. Not reality. When their theory fails, it’s not the theory. It’s the application of the theory. Or a greedy businessman. Or banker. It’s never their own stupidity. No matter how many times they get it wrong.
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