Wednesday, April 29, 2009

The Debits and Credits of Cigarettes and Food

(This article contains a highly simplified model of the economy, ignoring such things as the time value of money, and the unpredictability of health costs. What is important here is the broad concept.) (Also, the format of the accounting entries in this article is getting messed up by the website. Just remember, Debits on the left, Credits on the right, even if it's a bit uneven.)
Double entry bookkeeping is a beautiful thing. It is the yin and yang of the economic world. It demonstrates that there are always two sides to everything.
In this article, using simple double entry bookkeeping, I shall demonstrate that not all economic activities are created equal. In particular, the production and sale of cigarettes is not equally valuable to the economy as the production and sale of food. To demonstrate this, I shall go through some very simple journal entries, similar to anything that could be found in an accounting textbook. But unlike most accounting textbooks, these shall be journal entries for several entities listed in the same journal. The three entities involved here, which shall be denoted by letters in parentheses, are the Tobacco User (U), the Tobacco Retailer (R), and The Rest of Society (S). Remember, Assets = Liabilities + Equity, and as you shall see, the key difference between food and tobacco consumption is in the liabilities. Our first journal entry happens when a retailer purchases a pack of cigarettes for resale.

Tobacco Inventory (R) $x

Cash (R) $x

Next, the smoker purchases from the retailer. (m = markup for retailer).

Tobacco inventory (U) $x+m
Cash (R) $x+m
Cost of goods sold (R) $x
Cash (U) $x+m
Tobacco inventory (R) $x
Sales Revenue (R) $x+m

Now, the smoker consumes the tobacco. We all know that smoking causes health problems, and that these health problems are a burden to the smoker, and the rest of society. So to take this into account, a liability shall be part of the journal entry. This liability will be equal to the total cost to the smoker, and the rest of society of bad health brought about by the consumption of the tobacco in question. We will divide up the bad health expense and liability into proportions paid by the User and by the Rest of Society by using the variables Bu and Bs. (We shall lump the retailer in with the rest of society for simplicity's sake). Here, is what happens when the smoker smokes:

Tobacco expensed (U) $x+m
Deferred bad health expense (U) $Bu
Deferred bad health expense (S) $Bs
Tobacco inventory (U) $x+m
Long term bad health liability (U) $Bu
Long term bad health liability (S) $Bs

Over the course of the smoker's lifetime this expense will be realized by both the smoker and the rest of society. This is the journal entry for that.

Bad health expense (U) $Bu
Long term bad health liability (U) $Bu
Bad health expense (S) $Bs

Long term bad health liability (S) $Bs
Deferred bad health expense (U) $Bu
Cash (U) $Bu
Deferred bad health expense (S) $Bs
Cash (S) $Bs

Society's net income or loss from this entire transaction is equal to the tobacco retailer's profit from the transaction, m (x + m - x = m) minus the sum of Bs and Bu.
Here's the net income or loss for society:

Society's net income or loss = m - (Bs + Bu)

Now, what if the product in question, instead of cigarettes, was a healthy food item that caused no bad health liability or expense? Run through the same simulation and you will see that society's net income (and not a loss unless there is negative markup) will simply be equal to m.

Double entry bookkeeping exposes both sides of everything. In this case it has exposed the seedy economic underbelly of tobacco consumption. Though food and cigarettes may be accounted for in GDP the same way, using the wisdom of double entry bookkeeping, we can see through this. Clearly the two activities are not equally healthy, for people, or for the economy.

Monday, April 20, 2009

Investors or Inventors

There was an infomercial on T.V. the other day selling a groundbreaking system of stock market analysis, that when put into practice, would guarantee great returns; "We'll teach you how to get in when the stocks are low, and get out when they're high" etc. This was obviously a ridiculous scam. But it may be successful in drawing in victims. The stock market tantalizes people with the possibility of free money. But free money does not, and will never exist. All money gained from investments, (outside of that which arises from pure luck), comes from one of two sources, and both involve hard work:

1. Hard work by an investor in finding profitable investments.
2. Hard work by the invested-in company in gaining profit through its operations.

Nonetheless, in the American mind lies the fantasy of being able to sit at a computer and generate cash with the click of a mouse. People hope that somewhere there lies a perfect investment strategy. But the search for such a strategy is the modern equivalent of alchemy, and just like alchemy, it is a waste of time.
There can never be a fail-safe strategy of investing, because, no matter how sophisticated one's analysis of the stock market is, stock prices depend on an infinite number of unknown events that occur in the actual physical world. Only a piece of omniscient software could predict the future. Secondly, if a trader got his/her hands on this omniscient software, it would become useless if other traders had it too. The best that investors can settle for is to be sensible and manage their risk as much as possible.
Investment strategies are merely ways of siphoning money from the physical or intellectual assets of an economy. And if the productive capabilities of assets in an economy are impaired, it will become harder to make money as an investor. This is a law of financial physics. Even successful short selling depends on an initial price that reflects a perception of high productive capabilities. Securities' prices are merely shadows of the real economy.
Investment is the lifeblood of the economy, but careers as investment professionals are not what I hope the majority of kids of the next generation will strive to attain. I hope they will want to become inventors, not investors. (By inventor I mean someone who creates something new that is valuable to society). How useless would investors be if there were no inventors? There would be nothing to invest in. Inventors also need investors, to fund their endeavors. But good ideas will tend to attract investment. It does not take a degree in Finance to recognize a good idea. I hope the intelligence and creativity of the next generation, instead of going towards the alchemical quest of beating the stock market through technical analysis, will go towards innovations in the actual physical world. Imagine if the world's great geniuses decided to become stock traders instead of chemists, surgeons, authors, engineers etc. These geniuses might think of some great trading strategies, but there would be a lot fewer assets to invest in.
Pure speculation on the rising and falling of stock prices is a zero sum game. But sensible investment in good ideas benefits investors, inventors, and the economy as a whole.