Where does wealth really come from?

Some Americans falsely conflate wealth with money. Some seem to think that money, as wealth, is created by the Federal Reserve (the Fed). Even some politicians may be confused, encouraging the Fed to push programs like QED1, QED2, and QED3. We are not talking about the source of money, over which, in a mechanical sense, the Fed exerts a large influence. Instead, the real source of wealth creation occurs while growing the capital stock.

Another surprise to many people may be for them to realize that wealth does not actually come from Government spending. Mostly, what federal spending does is “prime the pump.” But money, real money, or wealth, that is, the stuff that makes the economy hum, actually comes from an increase in the capital stock. Let me explain.

Gross Domestic Product

While reading a basic economic textbook, one is almost immediately confronted with the notion of Gross Domestic Product (GDP). GDP is a measurement of economic activity. Economists have agreed that both the income approach and the expenditure approach lead to the same GDP number. The basic calculation is GDP = Consumption + Government Purchases + Investment + Net Exports. But the majority of people end up confused when hearing the factoid “nearly 70% of GDP is Consumer Spending.”

So what? Yes, Consumer Spending, or Consumption IS a component of GDP and a convenient way to measure the short-term direction of our economy. But, consumer spending IS NOT the primary cause of a growing GDP. Instead, Consumption is actually a secondary effect of a growing GDP.

Soft Data

Forget the hard data, look instead at the soft data. One of the best soft data measures of whether the GDP will grow is the Consumer Confidence Index (CCI), measured monthly by the Conference Board. The reason the CCI is important is that potential entrepreneurs often note the “temperature” of the average consumer, (and the CCI is one good attempt to measure that temperature) to determine whether risk-taking can and will be amply rewarded in the current and dynamic investment environment.

One of the senior writers at Fortune magazine, Geoff Colvin, spent years and thousands of words pointing out that the uncertain investment environment was the chief culprit for the eight years of puny recovery that followed the Great Recession. Today, however, Colvin is singing a different tune. The most recent Fortune magazine cover screamed, “The End is Near” – So we ask, the end of what? And the answer is: the end of a incredible stock market rise of almost 10,000 points (as measured by the DJI) or more than 35% in the last two years, since it became obvious that a President was coming into office who would stabilize the investment environment.

Wealth Creation

Here is the bottom line. If entrepreneurs (not regular folks like us) feel comfortable taking risks, then the 1) capital stock (or Investment, which is the PRIMARY cause of GDP growth) will soon grow. When the capital stock grows, then both 2) consumer income and 3) consumer spending will grow. If consumer spending grows, then the GDP will grow and wealth is created. There is NO OTHER WAY!

Part 2 of 10, Fraud Inoculation

Part 2 of 10

Background and History

The former CFO of a multi-location publishing house in the Greater Phoenix area is now serving time in prison (as of December 2011) for committing fraud and embezzlement. A detailed analysis of the before and after situations at the defrauded firm might prove instructive to any small business wanting to prevent material fraud.

The former CFO was in his thirties, married with four children. He attended church every Sunday, had a regular job with the Boy Scouts, was a college graduate, hard-working and trusted by all. In other words, he was the typical accidental fraudster.

My firm was hired to help out to determine if there was something inappropriate happening as cash was tight, even though business was good and the accounts receivable were healthy. But why were the financial statements were 7 months behind? (Red Flag!)

I requested bank statements from the former CFO (we will call him Ted, not his real name) several times, but I always received the excuse they could not be shared. Then Ted went on a second honeymoon to Italy, and finally the owner requested six months’ worth of bank statement copies sent to him from the bank.

One day later, as those statement copies included copies of all the check faces, I found fraud!

What is fraud and why does it happen?

What is fraud and why does it happen?

Simply stated, fraud happens when there is an accumulation of money, or at least a steady flow of cash or the equivalent, and a (formerly trustworthy) trusted party, managing that money, who decides to appropriate some cash for his or her own use. We call that type of theft, embezzlement. Most fraud is some form of “asset misappropriation”, the term used in the fraud examiner’s world.

Fraud is not a simple robbery, where force or a weapon is used to coerce someone to turn over valuable property of which the possessor rightfully controls. Instead of being trustworthy, the embezzler tricks the rightful owner of the property into thinking that the cash flow or the accumulated amount is still unimpeded and/or is not being diverted. That trickery is used to hide growing stolen goods, accumulating in value over time.

Who is guilty of this dastardly deed? According to the worldwide Association of Certified Fraud Examiners (ACFE) http://www.acfe.com/, around 85% of fraudsters are what is called in the parlance, an “accidental” fraudster. Those who defraud, intentionally participated in and perpetrated the fraud. That is part of the trickery. But “accidental”, is used as a modifier meaning that although the fraudster intentionally took the money, they did not begin the job intending to become an embezzler. It just worked out that way.

How does an accidental fraudster come to be? Well, in 1973 a sociologist named Donald R. Cressey, in a book called “Other People’s Money”, put forth a theory that explains about 85% of fraudulent behavior on the part of an accidental fraudster. Cressey’s theory is known as the Fraud Triangle. The three sides of this triangle are 1) Perceived unshareable financial pressure, 2) Perceived opportunity, and 3) Rationalization. Through a combination of financial pressure like an unknown expensive surgery for a loved one or a drug habit, or gambling debts, etc., ad infinitum, plus rationalization, then if given the right opportunity, most of us could become an accidental fraudster.

We generally do not know our employees well enough to know exactly what unshareable financial pressure they are facing. And unfortunately, we humans tend to rationalize on a regular basis. Therefore, the only real way to prevent fraudulent activity taking place is to prevent the opportunity from occurring. How might this be accomplished? Stay tuned for my next blurb


Is Fraud Inoculation Possible for a Small Business Firm?

Part 1 of 10

Definitions and Challenges

If by inoculation, one means 100% fraud prevention in the future, then the short answer is no. Webster’s dictionary definition of fraud includes the following two sentences, “No definitive and invariable rule can be laid down as a general rule in defining fraud, as it includes surprise, trickery, cunning, and unfair ways in which another is cheated. The only boundaries defining it are those which limit human knavery.”

This means that new ways to commit fraud are yet to be invented, and no serious person would ever claim to be able to prevent all future instances of fraud in a multiple-person small business. The more interesting question might be, “can essentially all material fraud be prevented, and if so, how?” Response to this question will be considered, analyzed, discussed and explained in detail.

For example, if the word ‘material’ is defined to be plus or minus one-half of 1%, then in a small business with annual revenues of $2 million, ‘material fraud’ equals $10,000. Therefore, perhaps the important question to consider is, “Is it possible to prevent material fraud (of $10,000 or more, annually) in a small business, and if so, how?”

In effect, the best way to minimize the likelihood and the size of future fraud is to come as close as possible to balancing cash daily. In this ten-part series, we will show how to do this, assuming that the owner keeps that cash balance in his or her head every day. Though the task may sound daunting, it is not, if one has the proper motivation.

End Part 1 of 10

Whose money is it anyway? How to Retire Modestly Wealthy

Whose money is it, anyway?

This blog, How to Retire Modestly Wealthy, etc., will include long and short essays regarding money, investing, embezzling, welfare, politics and even politicians who love spending other people’s money. Wherever there are accumulated dollars to be found, waste, fraud and abuse are sure to follow. In other words, fraudsters and politicians are always volunteering to appropriate and spend other people’s money. From time to time this blog will also include comments on the passing scene.

My first essay identifies a guaranteed method to become modestly wealthy.

How to Retire Modestly Wealthy – Guaranteed!

The General Rule

Many people know the assertion that the best way to make a small fortune – is to start with a large one! But that is not the only way, or the best way.

Let’s review the three major categories of investment possibilities that Warren Buffett addresses in a Fortune magazine article, (2/27/2012 issue) then seriously discuss a strategy that absolutely works for amassing modest wealth. The entire exercise of investing, of course, is to delay the gratification of consuming purchasing power today, to obtain greater, after-tax purchasing power, in the future.

Three Categories of Assets

The three broad categories of investment possibility are –

1) Currency-denominated assets such as:

Bonds, Money-market Funds, Bank Deposits, CDs, etc.

2) Unproductive assets such as:

Gold, Silver, Diamonds or even Tulips.

3) Productive assets such as:

Businesses, Farms or Real Estate, etc.

Buffett alleges that currency-denominated assets, though seen as least risky by many, in reality are the most risky, because of government politicians’ tendency to manipulate currency value (the inflation tax) for short-term political purposes.

Soon enough, the return on currency-denominated assets, after subtracting inflation and taxes, is zero, or close to zero. To quote Shelby Davis, “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

The most popular asset among non-productive assets is gold, seen as a safe haven by many today. But unproductive assets like gold never procreate. Please remember that one ounce of gold today is still one ounce of gold a thousand years from now, or even ten thousand years from now.

Both currency-denominated and non-productive assets are mostly popular because of fear, particularly assets like gold. Yes, the price of these types of assets may go up for a while, as the bandwagon for owning one or another particular non-productive or currency-denominated asset grows in popularity, but over time, bubbles always pop and price always fall back to earth.

Neither of these two asset categories ever meets the criteria of the real purpose of investment, which is to grow one’s future purchasing power, long-term. When bubbles burst as they inevitably do, Buffett observes, “investors who required a supportive crowd paid dearly for that comfort.”

The BEST Investing Strategy

May I point out, only investing in productive assets allows one to enjoy the possibility of increasing one’s future purchasing power for the long-term?

Specifically, the vast majority of one’s nest egg ought to be invested in productive assets, whether in owning real estate, and/or owning your own producing company, and/or owning equities (shares of productive companies), etc. Yet almost anyone would be lying if they said they knew exactly which productive assets to buy, when.

Because of this uncertainty, as well as short-term market and investment distortions, some portion of one’s investment pool should be cash, or S-T bonds, or even precious metals, as a hedge against inflation (5%?), yet the vast majority of our investment pool needs to be invested in productive assets.

Lowering Risk

One important key to follow when investing is to diversify widely, thus lowering one’s total risk. Remember, the future is always uncertain and unknown, therefore risky.

May I explain what this might mean? When buying equities, spread investment risk around by investing in many companies and in different industries. Whether your nest egg size is $20,000, $200,000 or $2,000,000, it is far less risky long-term to hold approximately the same dollar-size amounts of 40 or 50 companies in various industries, than investing your nest egg in only two or three firms. Yes, this widely diversified approach puts an artificial ceiling on your short-term gains, but it also constructs a solid floor that keeps away irrecoverable losses, which is much more important.

The same logic applies to real estate. Owning several smaller rental units and/or apartment buildings and/or commercial buildings in different locations is far better than owning just one large piece of real estate in one location.

Though most of us cannot afford to buy entire productive enterprises, like Buffett does, most of us can afford to own many smaller portions of productive companies. By diversifying our holdings, we lower our overall risk – portfolio theory and all that.

Lowering risk ought to be one of the biggest goals of prudent investing. Protecting one’s principal ought to be another. Read Benjamin Graham’s book The Intelligent Investor, (“if you read one book on investing, then read this one”, says the most successful investor who ever lived, Warren Buffett) before you really start investing. Then avoid as much as possible paying for other people to invest for you. Transaction costs often consume too much of the income generated by your wise investments – actually limiting the benefits of compounding interest.

The Nugget of Investing Wisdom

Due to compound interest (procreation working in your favor) following a prudent and diversified investment strategy will avoid catastrophic losses completely, protecting principle, lowering risk and growing your nest egg modestly throughout your life.

Let’s assume you are able to save 10% of your income, from age 25 to age 65. (There are many books written which discuss exactly how to save 10% of your income, which is not my topic today, but may I point out that the FIRST RULE OF INVESTING is to live on less than you earn!!!.) Say your annual income at this time is $48,000 a year. At a modest 7% annual return, your investment pool would grow to over $1 million. If you were able to average a 10% return, instead of 7%, that same $400 a month saved would then become a $2.5 million nest egg over 40 years! And an IRA can grow tax-free!

Over any 40-year period in the 20th century, the return on equities in America averages around 10%. However much purchasing power a million dollars or $2.5 million dollars allows will undoubtedly grant you sufficient purchasing power from ages 65 to 95 to live comfortably, I suspect. Even major medical emergencies near the end of life most likely can be paid for out of your still mostly-compounding nest egg.


If you follow these three simple rules of investing, 1) Live on less than you earn, 2) Diversify widely, and 3) Only Invest in Productive Assets, then I guarantee you will amass a modest fortune. On the other hand, many people behave in ways that are risky indeed and do not invest wisely. Which leads me to one final piece of advice – never play the lottery. Winning the lottery requires overcoming odds of 5 million to 1 or worse. You have a much better chance (perhaps 15 times better) of being struck fatally by lightning, which is a real, but unlikely risk that all of us bear.

Seize the day and choose to invest wisely and prudently in productive assets!


The Wonders of a Free Market #2

A student asks: But can citizens and the free market really fix themselves? A comment from the website of the Department of Justice (2011) states that the competitive process, which is within free markets, only works when competitors set prices honestly and independently. 

I guess I’m partial because I work for a state agency, but they do have their benefits. True, when the government steps in, their intervention never seems to be truly successful, but we as humans are imperfect, therefore an imperfect market exists; when there are such practices as price-fixing and bid-rigging it tells me there are flaws everywhere.

(2011) Price fixing, bid rigging and market allocation schemes.  Retrieved from http://www.justice.gov/atr/public/guidelines/211578.htm

My Response:

Basically, you are pointing out illegal ways that some people try to manipulate price in a free market, and just like you, I agree this illegal behavior calls for government action. It DOES NOT CALL for government price intervention, but rather either putting people in jail or heavily fining them for violating the rules of the game or simply removing them from the marketplace.

Just like you, I too want, and the free market needs, even demands, regular enforcement of a reasonable rule-of-law that fosters competition.

Yet a different take of that DOJ website citation might be that free markets only work when government enforcement reasonably and regularly enforces a reasonable rule-of-law such that competitors feel free to set honest and independent prices.  A meaningful motto might be: Government price intervention – never! Government refereeing, all-the-time!

However, let us look at this DOJ comment more carefully. First of all, the only way free markets really work is that almost all firms participating in a free market are price-takers, not price-makers or price-setters. They run the gamut from imperfect competition at one end of the competitive spectrum like gasoline stations and grocery stores to oligopolistic competition at the other end of the competitive spectrum where we have only a few competitors such as in cell phones or car manufacturing or cola beverages.

But just ask Nokia or Motorola or Research in Motion if the competition in the cell phone market is not bruising and brutal, for instance. Or ask Chrysler or GM about how kind their competitors are.

This observation does not include the rare market structure called ‘monopolies’, (often electricity companies) which are almost all heavily regulated by local, state-wide or regional government regulatory bodies, like corporation commissions. Nor does this observation fit a cartel like OPEC (an oligopoly supported by national governments), which manipulates supply, therefore manipulates price, which entities are outside of the reach of US law enforcement.

But few firms in America have sufficient market power to actually set the market price. So the DOJ is way off base, I think, in their notion. Whether prices are set honestly or dishonestly does not really matter. Practices such as bid-rigging and price-collusion are illegal almost everywhere.

Yes, I agree that someone in the firm sets a price for the firm’s product or service, then the consumers in the marketplace either buy the product or service, on not. But these type of ‘price-setters’ are really only gauging the market and mechanically setting a price at a level they think the market will bear. My I prove my point?

Take bread, for instance. If your neighborhood grocery store started charging eight dollars a loaf for bread that you could drive a bit farther and buy a loaf of bread at a dozen other nearby places for four dollars a loaf, how many of the eight dollar loaves would you buy? None, right? Why?

Because the free market, without government intervention, normally sets the price, based on supply and demand interaction and either your firm follows, or your firm might reap zero revenues.

This is true with almost any product or service, as long as there is a free market. This price mechanism is called the “invisible hand” and is the hallmark of free markets. Conclusion – Imperfect human beings DO NOT create imperfect markets very often, unless and until the government intervenes!