Financial Literacy – Markets – First, the economy.

In understanding markets, it is first wise to understand the environment in which they reside. This lesson is going to provide some very basic information on a high level view of the economy. This is a video who is narrated by Raymond Dalio, a legendary Hedge Fund manager and private investor who has made himself a billionaire by understanding the economy. In this video he explains how the economic system works and is really simple to understand, albeit, a bit long.

Lets cover the information in a shorter format.

Our economy is not some super complicated topic. It is an aggregate of a bunch of individual transactions. Just like you and I buy things and pay for services, so do corporations. No matter how huge a corporation is, they participate in transactions much like us. As all these transactions are added, they make up our economy. This number is also known as the GDP, or Gross Domestic Product. There are different sectors and industries and many people pay attention to the numbers of these different industries to indicate the health of our overall markets and use it as a proxy for the health of our economy. Debt is another form of money, but as we discussed in previous lessons, it is really borrowing against your future self. As you have to borrow against the future, your level of spending as to come down in order to service your debt. This ebb and flow of spending causes market cycles.

The Federal Reserve is the central institution that controls our money supply and is outside the reach of government. These two entities are separate from each other but frequently interact with each other in policies to provide influence on the markets. The federal reserve sets interest rates, which affect the terms that banks loan out money on. The higher the interest rates, the more expensive it is to borrow money, and thus, the more you are encouraged to save. The lower the interest rates, the cheaper it is to borrow money and the more you are encouraged to purchase on credit. It is also worth mentioning that the Federal Reserve is the institution that the United States government borrows money from. It isn’t a typical loan however, as the United States government has to sell assets in order to receive this money. This is typically done by the government issuing bonds, which is an I.O.U. with interest, in order to receive this money. What then happens is that the Federal Reserve then prints out United States currency, to trade for the U.S. bonds. If you noticed that this causes all sorts of interest rate problems, you are correct and quite observant. It seems counterproductive that an outside institution, which sets the interest rates, lends money to the government by printing money that did not exist before and in effect, devalues the existing money supply.

When all this credit comes due, it is the job of the Federal Reserve to gauge the printing of money because when credit is paid, the money disappears from circulation. It is then important to understand how much money is going to be disappearing and to print enough money back into the system so that there is no shortage of cash, in other words, so the system remains liquid. Over the short term this system causes inflation and deflation. Inflation is when there is more money in circulation chasing the same amount of goods. As money is printed and more and more exists in circulation, the purchasing power of each dollar becomes weaker, so you need more money in order to purchase the same item. Deflation is when the money is paid on debts and comes out of circulation. Since there is less total dollars in circulation, it takes less dollars to buy the same item than before. The Federal Reserve has a goal of maintaining about 2% inflation every year, and tries to control this by increasing rates so more money disappears from circulation and brings inflation into a reasonable range. If too much money is used to pay debts, deflation occurs and the Fed (Federal Reserve) prints out more money to cover that gap. It is important to note that our financial system will not function in a deflationary state. If long term deflation happens, people will simply hold cash, because the value of every dollar will rise as money disappears from the system. The value of existing assets will also decrease, causing businesses and individuals to appear less creditworthy because they have less cash flows (income), assets and collateral. This encourages holding onto cash and not spending. If people are not spending money, then the economy slows more and more until it stops altogether. Companies will not hire, invest, or spend money and so everything will come crashing down.

The largest participants in the markets and the economy are the consumers or retail investors. The common person is about 70% of the economy. Some important figures are the CPI or Consumer Price Index, which measures inflation by comparing a hypothetical basket of goods every year. If the price comes up, inflation is occurring and if it comes down deflation is indicated. Another important figure is the Federal Funds Rate, or the interest rate that the Fed has set. This lets you know what interest rates you and corporations are typically looking at for borrowing money. Real GDP is the total value of all transactions in the economy adjusted for inflation and the National Debt is the debts outstanding by the government and is the flip side of the financial coin when we speak about the United States government. Real GDP growth is the percentage at which the economy is growing and is important to understand. If for example, the economy is growing at 1.7% but the national debt is growing at 2%, you can see that this would be a bad situation to keep up for very long. The Unemployment Rate is just as it sounds, the percentage of people who do not hold a job that are searching for employment. With these numbers it is rather easy to roughly gauge the state of the economy. This is a LARGELY simplified view of the economy and of markets but one that is adequate for understanding what is going on. To understand specifics in the market more figures are needed such as rates that indicate new Housing Starts or the Manufacturing PMI (Purchasing Managers Index) which is a fancy way to say new manufacturing starts. While these numbers are undoubtedly important, with a relatively few numbers, you can tell whether the economy is doing well or if it is doing poorly.

Armed with this information on the background processes, the next chapters are going to be aimed more specifically on investments. It is important to understand the environment that the market is in to then understand and make sense of specifics in the markets themselves. This is going to conclude this lesson and in the next lessons, i will assume that you have watched the provided video and that it makes sense. If you have any questions on the information covered, do not hesitate to ask and i will answer as promptly as possible.

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