Mr. Moderate

Most people naturally wish to be wealthy. Wealth comes from one of two places: 1) you inherit wealth from somebody else who got it the other way; or 2) you earn wealth by generating profits through business activity. The larger the profit is, the larger is the associated contribution to wealth.

This can be illustrated in a number of different ways. Let me use an illustration based upon the development of raw land into a tract of houses. My illustration for this development activity involves four people. First, we have Bill Billionaire, who agrees to deposit $10 million into a bank run by Bob Banker. In return, Bob Banker agrees to pay Bill Billionaire $300,000 (3%) interest on that $10 million deposit. In order to be able to pay back Bill Billionaire all of his original money, plus the agreed profit (interest), Bob Banker needs to lend the money into a safe and profitable business activity. Bob is friends with Dan Developer, who presents Bob with a proposal for lending the money to him. Bob agrees, based upon the proposal, and the $10 million changes hands once again, this time in return for the agreement by Dan to pay back Bob all of the $10 million one year later, plus $600,000 (6%) of interest. So long as Dan does pay the money back when due, Bob has locked in a profit of $300,000 for his bank. Bob earns that profit by agreeing to take the risk of the loss of the $10 million, thereby protecting the investment of Bill Billionaire. Dan Developer goes to Larry Landowner and agrees to purchase a suitable piece of property for $4 million in cash. Larry may or may not have made a profit on the sale of this land. But that issue is not part of this illustration. Dan Developer then buys $3 million in construction materials and contracts for $4 million in construction labor and $1.4 million in advertising and sales expenses. The houses are built as they are sold to avoid overdrawing the checking account of Dan Developer which has in it only the $6 million left after the land purchase. A total of 100 houses are built and sold at an average price of $150,000 each. Thus, Dan realizes a total revenue of $15 million and total expenses of $13 million. This leaves Dan with a net profit of $2 million.

At the end of the above series of transactions, Bill Billionaire is repaid, and has a profit of $300,000 to show for his investment. This increases the wealth of Bill Billionaire by $300,000. Again, Larry Landowner may or may not have made a profit on the land, but he made no profit at all on the development of the land, so he has no profit and no increased wealth as a result of the land development business run by Dan Developer. Bob Banker has a $300,000 profit to show for his banking business, which increases the wealth of the bank owners by that amount, less whatever costs or expenses were involved for the bank to stay in business. And Dan Developer has a $2 million profit, meaning a $2 million increase in his own personal wealth, as we have fully considered all of his costs of doing business as part of this illustration. Other businesses that sold goods or services to Dan also may or may not have made a profit and realized an increase in wealth. Again, whatever profit they ultimately realize is what results in an accumulation of wealth on their part. If everything else is equal, the country overall had an increase in wealth of $11 million, since that is the difference between the value of the raw land ($4 million) and the value of the developed properties ($15 million). In this illustration, the increase in wealth was totally represented by an increase in hard assets. It is possible that the increase in wealth could be represented as an increase in value for some soft assets, such as contract rights. Whatever the form of increased value might be, the increased wealth means that the sales value of something has gone up over time, and that increase in sales value represents a profit to the owner of whatever has increased in sales value.

It is the function of business to generate profits for the owners of the business. In the simplest sense of an individual (sole) proprietor, the profits generated by the business are directly translated into the income of the individual owner. For so long as the owner retains those profits, those retained profits represent some part of the additional wealth of the owner. When you have a corporation, the profits are called “earnings” and the “earnings” add to the shareholder value of the corporation. Here, however, the individual shareholders may see more or less of the “earnings” reflected in the actual value (wealth) of their shareholdings. The reasons for this are complex, and have more to do with market psychology than they do the hard numbers of profit and loss. This is a difference with corporate financial operations, and that difference is outside of the scope of this particular page.

Meanwhile, the exact same concepts apply to your personal financial situation. If you have nothing at all but a job, then you are “in business” selling your own labor to the person or company whose job it is. That person attempts to buy your labor at a low price and resell it (usually in combination with goods and/or services from others) at a higher price, thereby making a profit for the company. But your profit is determined by the difference between what you are paid for your labor and the amount you spend (including taxes and benefit costs that are withheld from your pay) to maintain your own personal lifestyle. We call this personal profit “savings,” and statistics show that in the United States, the average person has been operating at a loss for several decades, spending more in expenses than they took in as income. This is expressed as a “negative savings rate” and it is not at all healthy for the economy as a whole or for the people who live and work within the economy.

If you adopt an attitude that profits are bad, then you will always be poor. It also means you will never have any savings as savings represents your personal “profit” from the business of running your own life. This view that profits are bad is, in effect, the mistake made by socialist and communist governments around the world. On the other hand, if you adopt an attitude that profits are to be maximized at all costs and without any regard to honest dealings, then you are a criminal because you have violated the rules of honest dealings that our business system relies upon. The next page in this series will discuss the need for a balanced set of rules for business dealings and the need for strong governmental enforcement of those rules. The correct attitude about profits lies someplace in the middle, where people accumulate the honest rewards for their honest business dealings and everybody is happy about it. Too bad that the real economy doesn’t happen to work this way. But that discussion, too, is outside the scope of this particular page.

The sole important point to realize from this page is that you can’t gain wealth without having profits. We will look at some of the issues about how to maximize wealth on other pages of this blog.