14 February 2006

Virtual Economy Vs Cash Economy

Almost everyday we're bombarded with anti-credit card campaigns, with newspapers and media denouncing the free availability of credit. Nevertheless, the number of credit card users is on the rise. If the credit system were so evil, why are we still favouring it? Are we missing something here? Is there some method to this madness?

Before we begin to bash up the virtual economy for its shortcomings, let us first understand what we are against, and if we really are against it.

Not very long ago, (assuming...) we had our much beloved and stable cash based economy. My Father, then in his prime, used to dutifully work for a month, get his paycheck on the 5th of subsequent month, and then set aside money for the expenses for the month, pay the house rent, my school fees etc., and a little for savings for buying that dream house by the end of his career. A typical lower middle class life. Nothing wrong with it. And it worked. Almost. That was our cash economony, WHERE YOU EAT WHAT YOU EARN, AND AFTER YOU EARN.

A few years later, the neighbourhood grocer got a little enterprising. He proposed to extend credit to my family on purchases for the whole month and we could pay him at the end of the month. A mutually beneficial deal. The grocer would get loyalty and a definite customer, while we would get cash-free and hassle-free purchases for the month, which had to be settled in the next month. Now the first month of this deal we had excess cash which would have gone to the groceries, if not for the deal. What we did with that cash is anybody's guess. This was the birth of our virtual economony. Nothing changed much in our lives, just that WE STARTED TO EAT BEFORE WE EARNED IT. So, the obligation with which had to live was to earn atleast as much to pay to grocer for the next month and the less visible obligation to procure goods from the same grocer, sometimes compromising on quality.

Now, who is actual beneficiary here? The shopkeeper took a little risk of giving credit to me, meanwhile ensuring himself of guaranteed sales for the month. I on the other hand got the service of hassle-free transactions with the obligation of raising enuf cash during the month. Both of us are equal beneficiaries. I pay for the service with my obligation. Thats how business is done. If I were a manufacturer, I would buy raw materials on credit, even If I were able to pay the supplier, becoz, cash in my business would create more value for me, and my loss is minimal as it is a zero-interest credit. The flipside of it is my liability has increased and If I fail to make up the money, I would be bankrupt. But a little intelligent financial planning and awareness my risk capacity is enuf to ensure I dont fall into this trap.

If that made my life a little simpler, I wanted more. (I wouldn't say better, as I still earn the same). Now I would have to purchase more than just groceries every month. So what do I do for these other purchases? This time, banks came up with the enterprising idea. The proposal this time was to provide me with cash for the whole month on purchase of goods sold my any seller anywhere, with the clause that I had to repay the month by the end of the month. As with every deal, this one too does have its costs and benefits. The benefit to the bank is that, it gets a transaction fee, usually paid by the seller, on every purchase. The cost to the bank is the risk of my credit. The seller gets more customers for a little fee and I get cash upfront for my purchases without any obligation to trade with a particular seller. Now the actual loss is to the seller who is to pay the extra transaction fee, without getting the loyalty of the customer and his loss in not being part of the deal is the rediced number of customers who trade. My benefit in this deal, as a customer, is to procure goods without having to carry enough cash each time, and the freedom from a sticking onto a single vendor. The cost to me was to bank with a single banker (although I am not too keen on banking with many of them) and the additional obligation of raising enuf cash to repay my debt. Now, even here the only thing that can save me from a debt-trap is my own skill at financial planning and my own awareness of my risk capacity. At the end of it, I started to eat more from the to-be-earned.

There is nothing bad or wrong about this. Just that everything we do has a consequence. In business too much depends on these promises and obligations. Suppliers would risk the payment and pass on raw materials to the manufactueres on credit. Manufacturers risk the payment and pass the finished goods to the warehouses or distributors on credit. Usually the period allowed for credit is a function of the frequency with which the orders come in. In case of groceries, it is one month. In case of share-trading, it is one Trading cycle etc. If the businessman who takes the credit has his finances wellplanned, takes calculated risks and repays his debtors in time, his credibility in the market increases, he can loan more money which in turn can be used to improve his business and his earning capability and so he builds a brand. This is the begining of brand building. If the businessman is not careful with his finances, overspends/overlends his assets, and hence is unable to repay his debtors, his reputation falls, his credibility reduces and so are his chances of doing business and getting new business. The same is true for credit-cards and individuals.

The availability of credit is not the reason of distress in either case. It is actually the credit-system which greatly accelerated the pace of increase in our standard of living. Bad financial planning is the culprit.

Now we move on the much touted Share Trading. Most of us feel that Share Trading is evil, speculative and is only a richman's game. Why should the rich earn money at the click of a button, while the poor toil in the soil? But isn't that the difference between them. The more intelligently you work, the more you can achieve, and hence the more you earn. A Turner in an industrial unit makes less money than the Manager who supervises the unit, though the Turner's work is physically more streneous. Some argue that not all work is simple and that physical work has to be done. But the choice is, either you do it and earn less or get it done and earn more. But if everybody chooses to delegate it, then who will do the work eventually? It is the person who chooses to do it, and doesn't mind earning less. It is each individual's choice of how much he earns. And, that is the basis of free economy.

In simple terms Shares, as their name signifies, are equivalents of quantity of ownership in the worth of a company. Not so simple, right. Lets suppose a group of enterpreneurs have an idea to set up a new company. They are able to garner some 10,000$. But their company needs 20,000$ to start. So, they float an IPO, asking the public to invest 10,000$ in their venture. So, we have 100 people from public, who invest 100$. each and get 10 shares each of worth 10$. Simple mathematics. So, whats so profitable in this?
Now, after 1 year lets suppose the company earns a profit of 4000$, out of which the management take their share of 1000$ for working for the company. Out of remaining 3000$, we invest back 2000$ back into the company and the remaining 1000$ is equally spent among the share-holders. The promoters get 500$ and the public get 500$. So, for each share a person gets 500/10000 = 0.05$ as profit, also known as dividend. If I had 10 shares, I will get 0.5$ as dividend, i.e, and at the end of 1 year my investment of 100$ fetched me a dividend of 0.5$. Not much.. for so much trouble, right! But that's not the complete story. Now the 2000$ which went back into the capital raised the company's worth from 20,000$ to 22,000$. Public's share of worth is raise to 11,000$, and there are 1000 shares in market. So, each share is worth 11$, and my investment of 100$ has become 110$. So far so good. Now, if I wish to withdraw my investment, take out the $110 and have a long holiday in Swizz, it is not as easily done. Since, the company does not wish to buy back the publicly held shares, I have to get hold of some other investor who is interested in buying these shares. It is here the Stock Exchanges come into picture. Stock exchanges are nothing but places to trade in shares. But, why should the price of the stock vary so much, if its worth is only 11$. Here is where the demand and supply effect the prices.

This year, the company starting with a capital of 20,000$ could earn a profit of 4000$. Extrapolating this, the company with its current capital of 22,000$ is expected to atleast earn a profit of 4400$. So, next year the company worth migh tbe 24,200$. of my 10 shares will be worth 121$ next year, if everything goes well. Now, when I go to the stock exchange to sell my shares at 11$, and I see a lot of people willing to buy these shares, since they also see the worth of 121$ next year, I increase my selling price as I see lot of demand for it. Lets say 100 buyers were interested at $11, only 50 might be interested at $11.20, only 2 might be interested at $11.50, and probably no one will be interested at $12, as the buyer will be at a loss, if he buys at 12$ and sells it at 12.1$ the next year (Inflation eats away his 0.1$ profit). So, I get to sell my shares at $11.5 (highest bidder). I get a cut of the YET-TO-BE-EARNED profit of the company and the buyer in the hope that the company will definitely make a good profit, settles for less profit and buys the share.

Now, suppose the company lost one of its major account and is not in a position to generate the anticipated 4400$ profit the subsequent year. If, at this juncture, I go to the stock market to sell the share, I might not find anyone willing to buy at $11. I might find someone willing to buy it at $10.8, and about 50 buyers willing to buy it at $10.6. So, I take a loss of $0.2 and sell the stock at $10.8. After I sell it at $10.8, the lone buyer who was interested at $10.8 is gone. So, the next seller would have to sell his stock at $10.6. This is how stock prices fall.

Who is the beneficiary here, what is his cost and his risk?
I put up $100 of my money in a venture risking its return for a year. I receive my fair share of profit in its sales. If I invest my money in a venture which is making profit, it earns profit for me and if I invest my money in a failing venture, I make a loss. It is me who has to select the company to invest, and decide on the amount to be risked. Any miscalculation might lead a loss to me. There is an argument that I do not work for the company, and hence I should not be entitled to its profit. It is my investment into the company that makes the work possible. Hence the investor is entitled to every bit of profit as the promoter is. The promoter in this case, in addition to his profit, gets his cut of $1000 for working in it.

Share trading is all about investing the available liquids asset into the right company, and if judiciously done, money in the economy will flow into those areas which are making high profits, and hence will attract more players into those areas, increasing competition. Capital flows into those areas which make high profits. Customers trade with those companies who can keep the prices down. The more the customers, the higher the profit. So, companies in effect reduce thier prices. Reducing their prices will drastically reduce their profitability. The only way out to for companies is to bring down their operating costs, so as to ensure increased profitablity. Those companies which can bring down the operating costs and can keep the prices low are the ones which eventually succeed. This is in effect the basis of capitalism.

Now, even here there is nothing wrong in Trading per se., it is actually beneficial for any economy to have a free and easy trading system. If somebody makes profit out of it, it is only becoz they are taking the risk of it.

But without an effective Trading system, public in general would be unable to invest in new ventures. Since, the enterprising enterpreneurs might not have all cash to setup new industries, the goverment would end up supporting industries or enterpreneurs themselves start taking loans from banks to setup industries. If neither is possible, only the rich will be in a position to setup industries, increasing the rich-poor gap. If goverment starts setting up industries, its involvement in core sectors like defence, infrastructure and health tends to get effected and we would end up having inefficient bulky governments. If only banks are to be banked on for loans, then surely the interest rates would go up and there would be more demand than the supply of cash (irrespective of how much the Central Regulatory Banks try to regulate the interest rates), which again reduces the profitability of the company. Any of the above 3 scenarios, result in reduced industries due to cash or administrative requirements and will result in increase in unemployment.

Virtual Economony is not a choice in modern economy, it is the cause of it.

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