On The Wealth of Nations and Neighborhoods, Part 1 – An Overview

The distribution of wealth around the world has caused severe turmoil, from the austerity protests in Greece, to the #occupy movement spreading across the globe. Most of the news coverage of late has concentrated on the viral spread of the movement, but I’d like to take a look at the root causes of the financial disparity from a slightly different perspective: the individual, the local business, the national business, the international business and ultimately how the interplay among these stakeholders has impacted the neighborhoods we live in (or perhaps neighborhoods we tell people to avoid).

Free Body Diagram ExampleI’d like to approach the analysis of income disparity by breaking the stakeholders down individually and analyzing the cash flow in’s and out’s as if each stakeholder was in a “bubble”. Now, I’m borrowing heavily from my mechanical engineering background – in this admittedly simplified analysis – by using something similar to a technique known as a “free body diagram” (image credit: Wikipedia). A free body diagram essentially takes an object in a particular orientation and strips away everything touching it, replacing the objects with representational forces acting upon the object, effectively turning an oriented body into a “free” body – thus the name. If all of the forces are in balance, the object stays still. If not, the object moves. Think of it like a person standing still on the ground. If a person weighs 150lbs (downward force) and the floor cannot push back with an upward force of 150lbs, the floor would fail under load and the person would fall through the floor. Say the same 150lb person was holding a helium balloon that was causing an upward force of 150.1 lbs, the person would be lifted off the ground and accelerate upwards according to Newton’s Second Law (F = ma).

I won’t be using the free body diagram metaphor to represent forces… instead it will be used to represent the flow of funds into or out of the object being analyzed. Green means cash in, red means cash out, simple! This example is quite analogous to an individual’s wealth because if an individual earns more money than they spend, their wealth increases over time (accelerates upward) when you take account the time value of money. The same type of analysis can be applied not only to individuals, but also to entire neighborhoods or nations: if the cash in is greater than the cash out, wealth increases – and vice-versa.

The Individual – You and Me

Individual cash flow diagram

The individual is the simplest and most tangible stakeholder, as all responsible adults are tasked with managing their personal finances. They also have some understanding of the impact of their decision making to manage the relationship between income and expenses. Most individuals have a single form of income, while others make a living by having several income sources. No matter the number of sources, let’s lump all of those together into a single bucket called “income” (cash in). All individuals have a dizzying array of different types of expenses, think real estate, food, clothing, etc., which can be affected by lifestyle choices (within certain constraints). We’ll lump all of these categories into a single bucket called “expenses” (cash out). Outside of food, clothing, and shelter, almost all expenses are discretionary, but individuals maintain optionality as to what kinds of food/clothing/shelter will be suitable for their lifestyle above a minimum threshold. In an ideal scenario, the amount of cash in should be greater than the cash out.

Local Businesses – Your Friendly Neighborhood Grocery

Local business cash flow diagram

The grocery store in your neighborhood isn’t much different than the individual since cash in must be greater than cash out, except the situation is slightly more intertwined. The cash out can have a major impact on other stakeholders in our model, namely, individuals. If the local neighborhood grocery store has employees, it has a direct impact on individuals in the surrounding financial ecosystem by providing income for the individuals.

The major individual stakeholder of the grocery store is the owner, who presumably gets a major portion of the profits that the store generates. Due to this, the owner’s income can be substantially higher than the employee income, dependent on the success of the business. Additionally, depending on whether the employees and owner live in the neighborhood where the business exist, this can be a net cash influx or outflow from the neighborhood. For the purposes of this example, let’s presume that the employees and owner live locally.

Additional stakeholders in the process are the vendors from which the grocery store buys it’s goods. This is represented by “cost of goods.” Similarly, real estate costs or rent are paid to the land owner. Depending on the place of residence of impacted stakeholders, be they individuals or businesses.

National Businesses – Fast Food Chains and Big Box Stores

National businesses are exactly like local businesses, except they are centrally managed and their revenue sources come from disparate places. The cash flow diagram for an individual location of a national business looks exactly like that of a local business, except the owner income or, alternatively, a portion of proceeds is guaranteed to go to the national entity, which immediately creates an outflow of cash for the neighborhoods in which the individual locations operate. Dramatic examples of this are McDonald’s, Walmart, and any other large chain operations with home we are familiar with on the national stage at one point grew into national businesses. 

International Businesses – Global entities

Although McDonald’s and Walmart were used as examples of national businesses, they have grown to become international entities with operations in all of the major markets of the world. Each of these companies has created a list of subsidiaries to act as independent “National Businesses” with the end goal of eventually repatriating profits back to the home country. Many of these businesses’ treasury departments have FX (foreign exchange) departments as well as individuals that focus on maximizing the return on those international profits from a taxation perspective. As an aside, treasury FX people are the ones that I used to deal with when I worked at Barclays Capital on the Corporate FX Sales desk. 

Foreign exchange and taxation are very interesting subjects, because both have a huge impact on the profitability of the parent company. For example, if the USA puts a huge tax on an American company that has operations in China, the odds are that the profits may live overseas for a while until that policy changes – likely, only if there is a view that the taxation policy will change at a later date. The same goes for FX. Favorable rates allow companies to repatriate cash sooner, but depending on the company, they may have fixed ways of operating that prevent them from taking a view on where FX rates are going. 

So how does this affect the parent company? This is revenue, or cash in. It just so happens that it comes from an international source rather than a source from within the same company. That same revenue is used to pay employees, pay for operating costs, and pay for other expenses.

Putting it all together

Stay tuned for part 2, where I will look at various socioeconomic situations and discuss how the different types of stakeholders impact each other.

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