Personal Financial Planning

Financial planning has to take into account conditions in the wider economy and in the markets that make up the economy. The labor market, for example, is where labor is traded through hiring or employment. Workers compete for jobs and employers compete for workers. In the capital market, capital (cash or assets) is traded, most commonly in the form of stocks and bonds (along with other ways to package capital). In the credit market, a part of the capital market, capital is loaned and borrowed rather than bought and sold. These and other markets exist in a dynamic economic environment, and those environmental realities are part of sound financial planning.

In the long term, history has proven that an economy can grow over time, that investments can earn returns, and that the value of currency can remain relatively stable. In the short term, however, that is not continuously true. Contrary or unsettled periods can upset financial plans, especially if they last long enough or happen at just the wrong time in your life. Understanding large-scale economic patterns and factors that indicate the health of an economy can help you make better financial decisions. These systemic factors include, for example, business cycles and employment rates.

Business Cycles

Ideally, an economy should be productive enough to provide for the wants of its members. Normally, economic output increases as the population increases or as people's expectations grow. An economy's output or productivity is measured by its gross domestic product (GDP), the value of what is produced in a period.

When the GDP is increasing, the economy is in an expansion, and when it is decreasing, the economy is in a contraction. An economy that contracts for half a year is said to be in recession; a prolonged recession is a depression. The GDP is a closely watched barometer of the economy. However, GDP can be considered a limited indicator of economic growth because it does not measure goods and services that are not paid for.

For example, caring for children or housework is not counted as part of GDP unless it is done by a daycare or a hired cleaner. Furthermore, GDP doesn't account for negative externalities such as the "harm done by industrial pollution or the health costs resulting from a polluted water system; these should be accounted as debits to the national income. Conversely, the benefits of clean water and clean environment are not counted within GDP."

Over time, the economy tends to be cyclical, usually expanding but sometimes contracting. This is called the business cycle. Periods of contraction are generally seen as market corrections or the market regaining its equilibrium after periods of growth. Growth is never perfectly smooth, so sometimes, certain markets become unbalanced and need to correct themselves. Over time, the periods of contraction seem to have become less frequent. The business cycles still occur, nevertheless.

There are many metaphors to describe the cyclical nature of market economies: "peaks and troughs," "boom and bust," "growth and contraction," "expansion and correction," and so on. While each cycle is born of a unique combination of circumstances, cycles occur because things change and upset economic equilibrium. That is, events change the balance between supply and demand in the economy overall. Sometimes, demand grows too fast, and supply can't keep up, and sometimes, supply grows too fast for demand. There are many reasons that this could happen, but whatever the reasons, buyers and sellers react to this imbalance, which then creates a change.

Employment Rate

An economy produces not just goods and services to satisfy its members but also jobs because most people participate in the market economy by trading their labor, and most rely on wages as their primary source of income. The economy must, therefore, provide opportunities to earn wages so more people can participate in the economy through the market. Otherwise, more people must be provided for in some other way, such as a private or public subsidy (charity or welfare).

The unemployment rate is a measure of an economy's shortcomings because it shows the proportion of people who want to work but don't because the economy cannot provide them jobs. There is always a so-called natural unemployment rate as people move in and out of the workforce as their lives change -for example, as they retrain for a new career or take time out for family. However, natural unemployment should be consistently low and not affect the economy's productivity.

Unemployment also shows that the economy is not efficient because it is unable to use all its productive human resources.

The employment rate shows how successful an economy is at creating opportunities to sell labor and efficiently use its human resources. Statistics Canada defines the employment rate as "the number of employed people as a percentage of the population aged 15 and older. The rate for a particular group (for example, youths aged 15 to 24) is the number employed in that group as a percentage of the population for that group." In contrast, the participation rate includes both unemployed and employed Canadians, or, as Stats Canada puts it, "The participation rate is the number of employed and unemployed people as a percentage of the population."

A healthy market economy uses its labor productively, is productive, and provides employment opportunities and consumer satisfaction through its markets. Table 1.2.1 shows the relationship between GDP and unemployment and each stage of the business cycle.

Cyclical Economic Effects

	Boom	Expansion	Recession	Depression
Rate of GDP Increase	Unsustainably High	Positive	Negative	Unsustainably Low
Rate of Unemployment	Unsustainably Low	"Natural" or Minimal	Higher	Unsustainably High

Table 1.2.1

At either end of this growth scale, the economy is in an unsustainable position: either growing too fast, with too much demand for labor or shrinking, with too little demand for labor.

If there is too much demand for labor -more jobs than workers to fill them -then wages will rise, pushing up the cost of everything and causing prices to rise. Prices usually rise faster than wages for many reasons, which would discourage consumption, eventually discourage production, and cause the economy to slow down from its "boom" condition into a more manageable growth rate.

If there is too little demand for labor -more workers than jobs -then wages will fall, or, more typically, there will be people without jobs or unemployment. If wages become low enough, employers will (theoretically) be encouraged to hire more labor, which would bring employment levels back up. However, it doesn't always work that way because people have job mobility -they are willing and able to move between economies to seek employment.

If unemployment is high and prolonged, then too many people are without wages for too long, and they cannot participate in the economy because they have nothing to trade. In that case, the market economy is just not working for too many people, and they will eventually demand a change (which is how most revolutions have started).

Other Indicators of Economic Health

Other economic indicators give us clues as to how "successful" our economy is, how well it is growing, or how well positioned it is for future growth. These indicators include statistics, such as the number of houses being built or existing home sales, orders for durable goods (e.g., appliances and automobiles), consumer confidence, producer prices, etc. However, GDP growth and unemployment are the two most closely watched indicators because they get at the heart of what our economy is supposed to do: provide diverse opportunities for the highest number of people to participate in the economy, create jobs, and satisfy these individuals' needs.

An expanding and healthy economy will offer its participants more choices –namely, more choices for trading labor and for trading capital. It offers more opportunities to earn a return or an income and, therefore, also offers more diversification and less risk.

Naturally, everyone would rather operate in a healthier economy, but this is not always possible. Financial planning must include planning for the risk that economic factors will affect one's financial realities. A recession may increase unemployment, lowering the return on labor -wages -or making it harder to anticipate an increase in income. Wage income could be lost altogether. Such temporary involuntary loss of wage income will probably happen to you during your lifetime, as you inevitably will endure economic cycles.

A hedge against lost wages is an investment to create other forms of income. In a period of economic contraction, however, the usefulness of capital, and thus its value, may decline as well. Some businesses and industries are considered immune to economic cycles (e.g., public education and health care), but overall, investment returns may suffer. Thus, during your lifetime, business cycles will likely affect your participation in capital markets.

Currency Value

Stable currency value is another important indicator of a healthy economy and a critical element in financial planning. Like anything else, a currency's value is based on its usefulness. We use currency as a medium of exchange, so its value is based on how it can be used in trade, which in turn is based on what is produced in the economy. If an economy produces little that anyone wants, then its currency has little value relative to other currencies because there is little use for it in trade. So, a currency's value is an indicator of how productive an economy is.

A currency's usefulness is based on what it can buy or its purchasing power. The more a currency can buy, the more useful and valuable it is. When prices rise or when things cost more, purchasing power decreases; the currency buys less, and its value decreases.

When the value of a currency decreases, an economy has inflation. Its currency has less value because it is less useful -that is, less can be bought with it. Prices are rising. It takes more units of currency to buy the same amount of goods. When the value of a currency increases, on the other hand, an economy has deflation. Prices are falling; the currency is worth more and buys more.

For example, say you can buy five video games for $20. Each game is worth $4, or each dollar buys one-quarter of a game. Then we have inflation, and prices -including the price of video games -rise. A year later, you want to buy games, but now, your $20 only costs two games. Each one costs $10, or each dollar only buys one-tenth of a game. Rising prices have eroded the purchasing power of your dollars.

If there is deflation, prices fall, so maybe a year later, you could buy ten video games for the same $20. Now, each game costs only $2, and each dollar buys half a game. The same amount of currency buys more games: its purchasing power has increased, as has its usefulness and its value. Table 1.2.2 provides an overview of how prices, purchasing power, and currency value change during periods of inflation and deflation.

Dynamics of Currency Value

	Inflation	Deflation
Prices	Rise	Fall
Purchasing Power	Decreases	Increases
Currency Value	Falls	Rises

Table 1.2.2

Inflation is most commonly measured by the consumer price index (CPI), which is a measure of inflation or deflation based on a national average of prices for a "basket" of common goods and services purchased by the average consumer as determined by the federal government. It is an accepted way of tracking rising or falling price levels, and as such is indicative of inflation or deflation.

Currency instabilities can also affect investment values because the dollars that investments return don't have the same value as the dollars that the investment was expected to return. Say you lend $100 to your sister, who is supposed to pay you back one year from now. There is inflation, so over the next year, the value of the dollar decreases (it buys less as prices rise). Your sister does indeed pay you back on time, but now the $100 that she gives back to you is worth less (because it buys less) than the $100 you gave her. Your investment, although nominally returned, has lost value: you have your $100 back, but you can't do as much with it; it is less useful.

If the value of currency -the units in which wealth is measured and stored -is unstable, then investment returns are harder to predict. In those circumstances, investment involves more risk. Both inflation and deflation are currency instabilities that are troublesome for an economy and also for the financial planning process. An unstable currency affects the value or purchasing power of income. Price changes affect consumption decisions, and changes in currency value affect investing decisions.

It is human nature to assume that things will stay the same, but financial planning must include the assumption that over a lifetime, you will encounter and endure economic cycles. You should try to anticipate the risks of an economic downturn and the possible loss of wage income and/or investment income. At the same time, you should not assume or rely on the windfalls of an economic expansion.