Schizophrenic Advice

Imagine that your brother has come to you for advice. He says that he is in debt up to his ears and is having trouble making ends meet.

You advise him as follows:

• Arrange a debt consolidation to reduce the interest cost.
• Stop using all credit cards - spend only cash based upon a strict family budget
  
• Set out a schedule of debt repayment and stick to it
• Reduce your discretionary spending by 80% (teach your wife and children that it is a time of austerity and that everyone has to pull together)
• Urge your children to get after-school jobs to fund their discretionary spending wishes (and ask them to set aside 20% of their earnings to help contribute to family debt reduction)
• If you get any raise at work, use 100% of the after-tax increase to accelerate debt reduction
• When all non-first mortgage debt is paid, start using the money stream previously dedicated to debt reduction for savings growth.
• Try to maintain a savings rate of 15% of gross income.
• If and when family income increases, as long as the savings goals are met first, family spending may increase accordingly.
  

Sound about right?

The fundamental economic problem that our economy is facing is that too high a proportion of our families and business corporations are in the same position as the imaginary brother. The advice given to one is sound for all. In other words, the sound course of action is what is referred to in Wall Street as "straightening up the balance sheet" - that is, reducing liabilities and increasing assets.

And the result is a depression, as demand for goods and services and credit collapse.

If he follows the advice, the brother's family spending will not recover for quite a while; not until the debt is paid off and a steady family savings program is established, and then only as family income rises. This process takes time.

During that time the "economy" of the brother is "depressed", in the sense that aggregate spending per year is reduced. But note that it is "depressed" from an artificial and unsustainable high level.

So too our national economy.

Our national politicians only gauge the health of the national economy based on the level of economic activity, not by looking at the economy's balance sheet. Thus, a healthy correction for the balance sheet is treated as a disease which must be stopped.

The politicians are using Keynesian justification to substitute federal government spending for the missing private spending, to try and maintain overall spending at a level which was clearly artificial and beyond the sustainable means of the economy as a whole. Even if this policy worked (it won't) it is inappropriate, because it is neutralizing the effort of the private economy to "straighten-up" the national balance sheet.

As if this were not bad enough, much of the federal spending is structured to induce the private sector to resume spending at the old level before the balance sheets are repaired. That would be like telling the brother that the decline in family spending is a disease that must be stopped, that he must resume his spending and borrowing immediately, and then offering him financial inducements to do just that.

In light of all this, if I had the foresight, I would have added two additional points to the advice to the brother:

• Resist financial blandishments of credit card companies and retail discount sales
  
• If the government gives you a stimulus check or reduces your taxes, use the money to reduce debt.

The proper role of Government in this crisis is to allow the balance sheet correction to work its way through the system, in other words, patience.

During this period the Government should ensure that individuals are not pushed to an economic level where starvation or homelessness result. That does not mean keeping people in homes that they can't afford; it means keeping them off the streets.

On the business side, the Government should save basically sound businesses, particularly those who are imperiled by an absence of customary credit. Government should do this because the bankruptcy of a business involves not only the rearrangement of asset ownership but the destruction of the the engine of wealth represented by the intangible assets of the accumulation of knowledge and skills of the employees and the organization of that knowledge and skill in a wealth-producing cooperative. However, it is not a proper government role to bail out fundamentally unsound businesses.

And Government should reduce taxes, to reduce the burden it places on the backs of individuals and businesses.

I said the Keynesian stimulus will not work. Why? Because, unless the stimulus money is nothing more than the result of running the government printing press flat out (which will eventually cause a massive wave of inflation resulting from the debasement of the currency), this spending must be funded by borrowing or taxes. Borrowing is funding deferred. So it must be paid for either with higher taxes now or higher taxes later. Taxes reduce the ability of the taxed to spend or invest - dollar for dollar.