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| Financial Thinking |
Financial planning has to take into account conditions in the wider economy and in the markets that make up the economy. The labor market, for example, is where labor is traded through hiring or employment. Workers compete for jobs and employers compete for workers. In the capital market, capital (cash or assets) is traded, most commonly in the form of stocks and bonds (along with other ways to package capital). In the credit market, a part of the capital market, capital is loaned and borrowed rather than bought and sold. These and other markets exist in a dynamic economic environment, and those environmental realities are part of sound financial planning. In the long term, history has proven that an economy can grow over time, that investments can earn returns, and that the value of a currency can remain relatively stable. In the short term, however, that is not continuously true. Contrary or unsettled periods can upset financial plans, especially if they last long enough or happen at just the wrong time in your life. Understanding large-scale economic patterns and factors that indicate the health of an economy can help you make better financial decisions. These systemic factors include, for example, business cycles and employment rates.
Employment Rate
An economy produces not just goods and services to satisfy its members but also jobs because most people participate in the market economy by trading their labor, and most rely on wages as their primary source of income. The economy, therefore, must provide an opportunity to earn wages so more people can participate in the economy through the market. Otherwise, more people must be provided for in some other way, such as a private or public subsidy (charity or welfare). The unemployment rate is a measure of an economy’s shortcomings because it shows the proportion of people who want to work but don’t because the economy cannot provide them jobs. There is always some so-called natural rate of unemployment as people move in and out of the workforce as the circumstances of their lives change—for example, as they retrain for a new career or take time out for the family. But natural unemployment should be consistently low and not affect the productivity of the economy.
At either end of this scale of growth, the economy is in an unsustainable position: either growing too fast, with too much demand for labor or shrinking, with too little demand for labor. If there is too much demand for labor—more jobs than workers to fill them—then wages will rise, pushing up the cost of everything and causing prices to rise. Prices usually rise faster than wages, for many reasons, which would discourage consumption that would eventually discourage production and cause the economy to slow down from its “boom” condition into a more manageable rate of growth. If there is too little demand for labor—more workers than jobs—then wages will fall or, more typically, there will be people without jobs or unemployment. If wages become low enough, employers theoretically will be encouraged to hire more labor, which would bring employment levels back up. However, it doesn’t always work that way, because people have job mobility—they are willing and able to move between economies to seek employment. If unemployment is high and prolonged, then too many people are without wages for too long, and they are not able to participate in the economy because they have nothing to trade. In that case, the market economy is just not working for too many people, and they will eventually demand a change (which is how most revolutions have started).
Other Indicators of Economic Health
Other economic indicators give us clues as to how “successful” our economy is, how well it is growing, or how well positioned it is for future growth. These indicators include statistics, such as the number of houses being built or existing home sales, orders for durable goods (e.g., appliances and automobiles), consumer confidence, producer prices, and so on. However, GDP growth and unemployment are the two most closely watched indicators, because they get at the heart of what our economy is supposed to accomplish: to provide diverse opportunities for the most people to participate in the economy, to create jobs, and to satisfy the consumption needs of the most people by enabling them to get what they want. An expanding and healthy economy will offer more choices to participants: more choices for trading labor and for trading capital. It offers more opportunities to earn a return or an income and therefore also offers more diversification and less risk. Naturally, everyone would rather operate in a healthier economy at all times, but this is not always possible. Financial planning must include planning for the risk that economic factors will affect financial realities. A recession may increase unemployment, lowering the return on labor—wages—or making it harder to anticipate an increase in income. Wage income could be lost altogether. Such temporary involuntary loss of wage income probably will happen to you during your lifetime, as you inevitably will endure economic cycles.
A hedge against lost wages is an investment to create other forms of income. In a period of economic contraction, however, the usefulness of capital, and thus its value, may decline as well. Some businesses and industries are considered immune to economic cycles (e.g., public education and healthcare), but overall, investment returns may suffer. Thus, during your lifetime business cycles will likely affect your participation in the capital markets as well.
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