Americans Don’t Understand Business, Economics and Taxes
Our economy is in the shitter because law makers, regulators, investors, speculators, CEOs, and small business owners don’t have an intuitive, or heck, even basic, grasp of economics and have completely overvalued the market.
Case in point: Joe the Plumber. When I first heard this Republican gas-bag open his condescending mouth at Obama, I thought his story was incredible. Here is an ordinary plumber, living the American Dream, trying to buy his own business. A business that makes $250,000 a year!
The word incredible has two meanings. I almost always use it to mean “WOW, that is AMAZING”. In this case, I am also using it to mean both marvelous and “so remarkable as to elicit disbelief”.
Joe’s story doesn’t make sense to anyone with the smallest bit of business and economics sense. Joe’s story reeks of Republican political propaganda which fails to understand basic economic theory.
Did anyone do the financial math on the Joe the Plumber story? The numbers he told the press do not add up.
My first clue that something was amiss was when he said that his business would earn $250,000 a year. My bullshit detector went off immediately, since only 2% of US Citizens earn more than $250,000 a year. Of course, everyone thinks that better off than they actually are, and that they might just eventually get there. It is the very definition of the American dream.
Then, I thought to myself, how much would I pay for a business that made me $250,000 a year? Thinking back to my business and economics classes at Washington University, I remembered a concept called discounted cash flow which estimates all of a business’ future income and gives them a realistic present value.
So, I plugged some numbers into this calculator and came up with some intriguing numbers. If Joe was trying to buy a business that profits $250,000 a year, he’d have to pony up over 2 million dollars to buy the business. I think that McCain’s comment to Joe that “congratulations, you’re rich” was spot on, especially since a median US household has a real net worth (wealth) around $93,000. The average US citizen has about $115 in a savings account.
That is a ton of cash for an “Average Joe”. More likely, Joe is trying to buy a business that brings in $250,000 in cash every year, and has $205,000 of expenses. You don’t just pocket all the money that a home owner gives you, you have to spend money on things like pipes and wrenches. And of course, the tax code does not tax you on these expenses…they are deducted from your business’ income.
But even at $45,000 a year profit, Joe would still need to spend $500,000 - or half a million bucks - to buy this business.
So, what would Joe get for buying a business for $250,000? He would be buying a business that profits about $27,000 a year. And at $27,000 a year, Joe would benefit immensely under Obama’s tax plan.
Sadly, Joe grossly overvalued the business he wanted to buy. According to MSNBC,”Ohio business records show the company’s estimated total annual revenue as only $100,000. Actual taxable income would be even less than that.”
Which brings us back to my original point, that everyone has overvalued the market. I mean, come on, $600,000 for a $35,000 house bought in 1970? The future value of $35,000 at 6% a year is around $350,000. 6% is around the historic rate of return of the stock market. You’d have to assume a 7.5% interest rate to get a $600,000 value.
But hold on a moment, why are we using the stock market as a benchmark for real estate? The historic rate of return on real property is between 1 and 3 percent, which would mean this house should be selling somewhere between $60,000 to $100,000 today.
I think that this is because everyone was making an opportunity cost calculation. If you could make 6% on the stock market and take out a mortgage on your house by borrowing $100,000 at 1%, you’d make a quick 5% ($20,000). I think that demand caused housing prices to go up, especially since borrowing cash was made artificially cheap by the Fed. People started rolling their money into new money making houses, to avoid capital gains taxes, which also put upward pressure on housing prices. Everyone was playing the Martingale, doubling their bets while they were taking financial balance sheet losses. People would buy a $100,000 house, but would borrow $120,000 to make improvements, hoping to sell at $150,000. And then they bought a $250,000 house, with no money down, and borrowed $275,000.
Meanwhile, the lenders were creating all sorts of complex exotic investments based on residential real estate. Wall Street was financing Joe the Plumbers new kitchen. Does this sound like a good investment to you?
So, when housing prices dipped, our economy collapsed because the banks and fund managers were holding the proverbial hot potato, since the underlying properties were worth less than they were owed. Woops.
Once housing prices collapsed, the rest of the market did a reality check. Why were they paying $40 a share for a business that only profited $1 a share? No wonder these stocks plummeted to $6. Some of them plunged even further, since companies have been lying about earnings and bad products, further reducing confidence in the market.
So, why are Americans so dumb when it comes to economics and taxes? Primarily, its a lack of education. Most people don’t know the difference between marginal utility and a utility bill. And most people can’t explain the difference between a median, a mean, and an average. Appying basic math to difficult concepts is difficult for most people. So, we can try to teach our children and teenagers economics…but what about adults, those citizens voting in our elections? Listening to our politicians and news broadcasters creates so much misunderstanding.
