Recent news that the Federal Government will be backing away from insurance of high cost loans has created a high level of concern by many who own, sell, and finance high-end homes.  The mathematics behind this decision and its implications will be felt throughout the economy.

The first thing to understand is that the Federal Government currently guarantees nine out of every ten home loans that are made.  This means that the losses stemming from home value declines has ultimately landed on the government.  As these losses continue to mount, it is becoming more and more apparent that the system of government guarantees for private market activity is economically unsustainable.

The implications of this insight are very far reaching, since the government guarantee of mortgages has resulted in much lower interest rates than would have been available if banks were taking all of the default risk themselves.  This meant that many people were able to afford much larger houses than they otherwise would have the income pay for at higher rates.  In turn, this meant that there was room for home prices to grow because of this influx of new borrowers who could afford to purchase more expansive homes.  This effect created a ‘bubble’ where people bought homes they could not pay for based on the assumption that the prices would continue to escalate indefinitely.  When the point was ultimately reached where prices stopped rising and people were unable to pay their mortgage obligations, the bubble collapsed.

This is not a particularly surprising event for those who have studied market bubbles in the past, since all bubbles inevitably crash.  The thing that makes this bubble especially unique is that the government is only making token efforts to avoid the creation of another bubble that is similar to the last one.  Simple mathematics says that if loans are guaranteed by the government, riskier loans will be made for higher amounts than would have resulted if prices were set by market forces instead of based on administrative fiat.

This has created a bit of a monster for politicians, since most are aware that the current mortgage model is unsustainable but none of them want to be the ones to remove mortgage subsidies for the large middle class voting block.  Thus, the first step in this slow regression toward reality is removing loan subsidies for high-end homes.  This action can be justified on populist grounds by saying that it will only affect those who are already affluent.  And it will most certainly effect people with high-end homes.  The lack of government guarantees will almost certainly raise the cost of borrowing through higher interest rates and decrease the amount of home that buyers can afford.  This will ultimately result in less buyers bidding for properties and lower prices for people who are selling.

Most people will not feel a terrible degree of sympathy for people who purchased an $800,000 home that is now worth $500,000 since the government lacks the resources to subsidize these people’s loan activities.  However, there is a critical nugget of insight that this analysis begins to uncover.  This insight is that the government lacks the financial resources to subsidize anybody’s loan activities.  It’s just that the people in charge have been too cowardly to admit the mathematical reality.  This reality is that the resources required to fulfill promises made by multiple generations of politicians simply do not exist.

Thus, it is very true that the government cannot afford to subsidize wealthy homeowners.  But it is equally true that the government cannot afford to subsidize all of the other homeowners as well.  The accumulated losses from the real estate bubble are placing a financial burden that is being financed with borrowing and inflationary money expansion.  The stark reality is that current levels of government spending are unsustainable.  This mathematical fact will eventually come to bear in one manner or another.  Thus, while the context of a discussion may be about loan subsidies, tax credits, or whatever proposal is in the cross-hairs on a particular day, the real discussion needs to be about when the government will finally acknowledge mathematical reality.

In short, mortgage mathematics work out such that the cost of borrowing for high-end homes will become more expensive, and then be quickly followed by the cost of other borrowing becoming more expensive.  The implicit subsidy to home prices that have been provided by the government has lulled many people into a belief that the economy is on a road to recovery.  The truth is that this road stretches on for much farther than we have been led to believe, and still has many more bumps left in it.

What people must come to realize is that these adjustments are inevitable.  They will either come sooner and be smaller or come later and be larger.  One way or another, many of the promises, guarantees, and other explicit or implicit subsidies granted by the Federal Government will need to be pulled back.  When this eventually happens, it will result in an economic shock as entities that have come to expect government aid struggle to survive on their own.  However, this shock will result in the systematic allocation of capital by investors  toward projects with a higher natural rate of return, instead of being steered based on the availability of subsidies.

The bottom line is that many people will be quite unhappy when the point of final capitulation is reached, and reality is finally accepted by the government.  However, the marketplace that emerges after this inevitable period of difficulty will be more robust and resilient.  Ultimately, this adjustment will prove to be a necessary step for continued economic growth.  If is not a comfortable message to digest, but the sooner that we internalize this reality, the sooner we can reverse our course of chasing after market bubbles and return to a trajectory of long-term growth.

 

Knowledge and power are both deep and influential topics.  There is a popular sentiment that knowledge is power.  This sentiment stems from the fact that people who are educated and skilled have much greater opportunities to influence the shape and direction of their lives.  As time has moved forward, knowledge has become increasingly specialized and increasingly dispersed among a larger number of people.  In short, the power of knowledge comes from specialization and that specialization is no longer concentrated in a handful of metropolitan areas.

This is where the impact of politics creates problems.  Political solutions are frequently created and implemented by a central authority.  This can be a city council, county agency, state, or the federal government.  In each case, a council of experts are gathered by the political authority to study the situation and make recommendations.  In some cases, public agencies become hotbeds for corruption and influence by corporate interests or unions.  These circumstances make for popular news stories and special reports. However, there is a deeper problem that is largely unknown and frequently unreported.  With the world becoming increasingly complex, knowledge becoming more specialized and the people possessing that knowledge becoming more dispersed, it is literally impossible for any central agency to possess enough knowledge to create an optimal solution.

Over time, this problem has grown in scope and impact since the number of government representatives has stayed the same while the population and size of government has grown.  Consider that the the US legislature currently has 100 Senators and 435 Representatives.  This total has not changed for a very long time, so with each passing year the number of people represented by each person in congress increases.  Similarly, the political power of each person in congress increases.  With this trend of more power becoming concentrated in the hands of government, the impact of mistakes becomes increasingly stark.

It is important to consider that when the number of people represented by an individual increases, it becomes impossible to individually know a significant number of the people you represent.  This means that elections become an exercise in marketing and messaging instead of campaigning to people whom you personally know.  This means that large amounts of money are required to spread a message to many people whom you need to influence in order to win the next election.  This phenomenon results in shifting influence away from individuals, toward large contributors such as special interest groups, corporations, and unions.  Even in an environment that is absent of overt corruption, the influence of large organizations will necessarily trump that of individuals.  In most elections, there is a small field of candidates and none of the candidates completely represents the interests of any voter … people simply vote in favor of the person who they believe are likely represent their interests the most closely.  Even then, most elections result in between 1/3 and 1/2 of the electorate (i.e. people who voted for the opposing candidate) are unrepresented.

Thus, the question becomes one of the best way to create results in a world where knowledge is specialized, that specialization is widely dispersed, and decision power is becoming concentrated.  The current situation is one where people in power have far too much power, and create initiatives that are (supposedly) well intentioned, but fail to produce results.  One way to address this issue is to increase the number of representatives in government.  Another option is to decrease the size and scope of government so that market-based solutions emerge.

The notion of increased representation in government is appealing to many, due to the intellectual appeal of legislators who are members of our community.  This is most certainly preferable to the current situation, but still carries the implicit problem of trying to make centralized decisions in a world where knowledge is specialized and dispersed.  It is possible that this these centralized decisions will be incrementally beneficial to those who are currently under-represented, but will not address the fundamental problem of centrally planned solutions.

The idea of market based solutions is appealing to many in the business community, because it allows them more freedom to create products and services that can profitably benefit their customers.  The unique power of markets is that the dynamic process of trial and error allows for ideas and solutions to emerge from the specialized knowledge people possess, and is not constrained to a particular geographic area.  The aspect of markets that many people find unappealing is that the outcomes they create are not always the same ones that they personally desire.  Competition necessarily means that some people will be more successful than others.  Relying on voluntary charitable donations necessarily means less funding than would be available through a government agency that is financed with tax revenues.

The fundamental question that individuals must answer is not one of whether markets are ‘good’ or ‘bad’ … those descriptions are highly subjective, and lack intellectual depth.  The question is whether we prefer to pursue centrally planned solutions that we know to be sub-optimally effective, but are able to be directed.  In contrast to this is markets, where more products, services, and solutions emerge but results are produced that many people do not find desirable.  Fundamentally, the choice is between a sub-optimal solution that we can direct and a more optimal solution that we must allow to emerge.  The question of knowledge, power, and politics ultimately comes down to whether you value the ability to direct outcomes over the generation of greater output and opportunity.  The result of this choice is ultimately less important that the understanding that a choice must be made.

The great fallacy of utopia is quickly becoming revealed.  There is no perfection … only varying degrees of trade-off decisions.  We make these trade-off decisions as individuals, and as an electorate.  As each of us go throughout our lives, it is important to understand these decisions, and their extended implications on our personal, professional, financial (and political) lives.

 

There is an old proverb that states you should be careful what we ask for, because you just might get it.  The wisdom of this insight lies in the fact that most things we want are accompanied by undesirable consequences.  Children and adolescents frequently desire things that carry unwanted consequences with them, but generally lack the foresight to see the future impact.  Part of the responsibility implicit in becoming an adult is to anticipate when ‘getting what we asked for’ will result in something very unpleasant.

Unfortunately, this principal seems to be very difficult to communicate when it comes to electoral politics.  Evidence of this assertion is found in the general trend amongst free electoral systems for the populace to overwhelmingly support political candidates that promise to give ‘free’ services from the government.  However, very few people stop to consider where the resources for these government services will come from.

For example, the United States has a very large entitlement liability from Social Security and Medicare that is likely to result in tremendous demands for payment in future years.  (The current ‘bailout’ initiatives feed this phenomenon as well)  The options for raising the money necessary to meet these obligations all involve undesirable effects.  The ‘best’ alternative is for the economy to grow tremendously over the coming decades, creating a large increase in the tax base.  This alternative requires that the government maintain pro-growth policies for an extended period of time, while holding spending in check . . . all of this in spite of pressure to further increase entitlements.  The next alternative is for the government to either drastically increase taxes or issue new debt for the unfunded liabilities.  Unfortunately, this option constricts the economic activity that is necessary for generating future tax revenues.

The final alternative is to simply ‘print money’ or devalue the currency by increasing the amount of money in circulation by simply issuing new treasury certificates into the open market.  This is far and away the most likely scenario, because is the least visible and doesn’t require a direct vote by the legislature.  The unfortunate end result is that the increase in currency will cause large amounts of inflation that devalue savings, home equity, and entitlement payments.  Thus, the very same people who have demanded entitlements for many decades may see that the actions needed to finance their entitlements will ultimately erode the value down to where they would be better off if no entitlements had been created in the first place.

 

The current economic and political environment is one that has become increasingly polarized.  News continues to come in about a building US government debt spiral that is running a very real risk of destroying the international prominence of US dollars in the global marketplace.  There are serious problems on the horizon if large efforts are not made soon.

In response to this situation, people react predictably according to their political persuasion.  Those of a left-leaning persuasion exhibit a noted tendency to blame all economic problems on President Bush, high-income earners, and foreign military operations.  Similarly, those of a right-leaning persuasion are more likely to blame President Obama, and government spending.  However, there is a key principal that people on both sides frequently miss.

For the sake of argument, let’s say that all of the nation’s problems are the responsibility of George Bush / Barack Obama.  (Pick whichever name makes you feel more vindicated)  Now that we have “proven” who is responsible for all of the country’s problems, what are you going to do next?  In response to this question, most people will trail off into some manner of semi-coherent mumbling about fiscal policy, national priorities, or some other form of rehearsed phrases.  Moreover, this narrative completely misses the point of the question.  Most people get so wrapped up in what they think other people should do, that they completely lose focus on what they should be doing.

Thus, the important question for people to ask themselves is not whose fault the problems are, or even what the government is going to do about it.  The wheels turning those cogs will continue to spin with or without our constant attention.  The prescient question for each person to ask themselves is what they are doing for their own future and that of their family.  What decisions will you make right now that create a future of happiness and prosperity?  What sacrifices are you willing to make now for the sake of your future?  Are you prepared to rely on yourself when cuts to government services become unavoidable?

The answer to this question will frame the future of your personal, professional, and financial life.  The difference between informed achievers and self-indulgent whiners is the propensity to take action.  What action are you going to take today?  Are you going to start a business to create an additional stream of income?  Are you going to build an investment portfolio to gain greater control over your financial future?  The exact decision that you make is less important than making a decision and taking action.

In the end, each person is ultimately responsible for the well being of themselves and their family.  The government has made more promises than can possibly be financed, so dramatic changes of one stripe or another are inevitable.  That’s not politics, its math.  Smart players in the game of life will focus on the decisions that enable them to gain greater control over their personal, professional, and financial life.  The unfortunate truth is that there are many undesirable things in the world that we have no ability to control.  Excessively worrying about them only serves to distract our attention away from the actions and decisions that bring us closer to control over our own future. It is certainly worthwhile to stay up to date on the events of the day, but study them from the perspective of a person who takes thoughtful action.  This will train your mind to see opportunity so that it can be captured with intelligent action.

 

In the 1989 movie “Field of Dreams” Ray Kinsella hears a voice whisper telling him “If you build it, he will come.”  As the story continues, the voice once again urges Ray to “go the distance.”  This serves as a fitting metaphor for the attainment of personal and professional success.  In the sport of baseball, going the distance is the term used to describe a pitcher who plays for all nine innings of the game.  In boxing, it refers to a fighter who continues for all of the rounds.  In the context of success, it is an appropriate term to describe somebody with the persistence to keep working for their goals until they are achieved.

The importance of going the distance is illustrated in many endeavors where it is easy to quit when signs of difficulty emerge.  When attending college, it is easy to walk away when your desired results are not achieved in a class.  When working in a job, it is easy to quit when things get difficult and seek more desirable circumstances.  When building a business, it is easy to become downtrodden by growth and cash flows that do not meet your expectations.  When investing for the future, it is exceptionally easy to allow disruptions such as tenant evictions or market corrections to derail your strategy.

However, in each of these cases it is critically important to “go the distance” and see your goals through to completion.  In the beginning, this must be done completely on faith.  The reason for this is because most worthy goals do not materialize immediately.  Achieving them requires the patience and maturity to visualize future success and make sacrifices so that it can be achieved.  This stands in direct contrast to the juvenile immaturity of popular culture that worships immediate gratification.

There is a simple, but profound way to measure your progress on the road of success.  By engaging in daily self reflection where you honestly assess whether you have done everything possible to create your vision of success in that day.  (Each person should have their own unique vision of success that guides this analysis)  If the self assessment is done honestly, it should regularly reveal actions and decisions that can be made differently in the future.  Over time, this will create a cycle of continuous self-improvement.

Once the result of your efforts begin to become apparent, it will build a series of success that compounds upon success.  The important part for most people is reaching this point where their achievements become visible and tangible.  This provides inspiration for future efforts and victories.  Most people never reach this point of vision, because they quit before any of their efforts produce results.  By a simple failure to “go the distance” it can trigger a lifetime of failure and disappointment.  By seeking the easy way out, it can create a downward spiral of wasted opportunity that is never regained.  Each person must make their own choices.  The question to ask yourself is whether you are willing to pay the price of success through persistent effort?

Fiscal Food For Thought

The current economic difficulties in Greece and Portugal have brought some very important realizations to bear.  The most pronounced is that nations (just like people) cannot spend more than they produce indefinitely.  As debt and deficits mount, there is a tremendous temptation to inflate the currency as a way of financing the deficits.  As confidence in the fiscal health of a nation wanes, the interest rate required on its debt will increase.  For countries that are members of an economic union, their membership could be placed in jeopardy.  Ultimately, what happens is that tremendous reductions in government spending must necessarily occur.  The reason for this is because taxes cannot be raised indefinitely without pushing out a critical mass of productive economic activity that plunges the nation into a perpetual downward spiral of recession.

The way that such profligate and irresponsible spending becomes commonplace for a government is when the political authorities use public resources to influence votes that keep them in power.  This create an ever increasing desire for more public spending so that the government officials can stay in power.  Furthermore, many corporations quickly learn that there are great rewards available if they successfully lobby the government to provide bailouts, favorable loans, or regulations that protect them from competition.  In some cases, businesses discover that they can reap greater rewards from lobbying the government than by engaging in normal business activities.  However, what happens if too many businesses attempt to support their livelihood through favors from the government?

 

As we move throughout life, we frequently hear glowing speeches from political figures about the responsibility to our posterity.  For some reason, these concatenations of rhetoric seem to be frequently accompanied by a proposal for profligate spending that will enslave our posterity into an eternal spiral of debt.  Furthermore, this propensity does not seem to stop with any particular political party.  The Bush administration racked up a record amount of debt that has already been eclipsed Obama administration, with the trajectory set for an expansion of national debt that shatters all previous records many times over.

Government has become a big party where each new guy tries to out-do the guy that came before him.  Like with all parties, there is a next-morning hangover to deal with.  Unfortunately, the solution sought by our government is to keep partying in hopes that the hangover can be forestalled indefinitely.  (Or at least until the next guy is in office so that he can take the blame)  This series of buck-passing from one administration to the next will only turn the inevitable hangover into a crash-and-burn.  And on top of all this, the cost of this massive party is being paid for with borrowed money, the tab for which will be inherited by our children.

The truly frightening aspect of this national spending binge is that it is being undertaken for no meaningful purpose other than to secure re-election by politicians who seek to use public resources as a means to influence voters by providing social programs and subsidies.  As this phenomenon compounds over time, the government will be faced with the prospect of either raising taxes to crushing heights, accelerating the debt spiral by continuing to finance overspending by crowding out private capital in credit markets, or by devaluing the currency through monetary inflation by the Federal Reserve.  Of all the scenarios, inflation by the government is far and away the most likely, since money can be printed without congressional legislation.

In the end, this amounts to stealing from posterity so that the current political leadership can continue their ride in the seat of power.  It would be nice to think that responsibility will be returning to government in the near (or distant) future, but there is little evidence to support such hope outside of wishful thinking.  Because of this, it would be very wise to seek opportunities in assets like investment real estate that produce regular cash flow, and are financed by fixed-rate debt that will be devalued as the ravages of inflation are unleashed by government monetary expansion.

 

One of the concepts that is prevalent in economics is the notion of moral hazard.  Generally speaking, a moral hazard is created when one party in a transaction is shielded from risk because of government protection, or access to information that the other party lacks.  This concept has received a lot of media attention recently, because of the financial crisis involving subprime debt and credit default swaps.

The way that the moral hazard plays out in the financial sector is that the government implicitly shields financial institutions from bankruptcy based on a historical precedent of bailouts for institutions deemed ‘too big to fail’ by the authorities.  When executives and fund managers become aware of the fact that the government will not allow them to go bankrupt, it creates incentives for dramatic risk taking since the gains will generate large bonuses for the company executives and any the company creditors will be made whole by the government in the event of a financial catastrophe.  This phenomenon is frequently referred to as ‘privatizing the gains and socializing the losses.’

The unique irony of our current situation is that government policy has been implemented in such a way as to purposefully manufacture moral hazard by nature of how laws and regulations were written.  The mortgage industry has long been driven by the policies of Fannie Mae, the quasi-governmental agency who purchases mortgages in the open market.  (The reason why I refer to it as quasi-governmental is because of the implicit guarantee provided by the government that Fannie Mae will be insulated from losses by bailouts from the taxpayers)  Since Fannie Mae has an implicit taxpayer guarantee, it is heavily regulated and influenced by Congress and the Senate.

Because of the status that Fannie Mae enjoys as the market leader in purchasing mortgages, its policies have the ability to ‘market make’ throughout the financial sector.  Thus, as political pressures impacted the practices of Fannie Mae in regards to high-risk lending, those practices rippled throughout the mortgage industry.  The extended impact of this ripple effect was that banks could ‘pass the buck’ of risk with subprime mortgages to Fannie Mae by selling them their mortgages.  Thus, the policy of government has been to literally manufacture moral hazard by using the power of Fannie Mae to influence incentives in the financial industry.

Another unique irony of the current situation is the conclusion reached by the political authorities in response to the financial crisis.  Since there was a noted problem of ‘privatized profits and socialized losses’ the solution sought was to socialize the industries instead of privatizing the losses.  This socialization has not taken the form of financial institutions that were forced to accept government capital, and then forced to follow a long list of constantly changing rules and regulations because of the fact that they have government capital on their balance sheet.

In the end, it seems that a much more simple and effective solution would be to simply privatize the losses from this crisis so that investors and fund managers will learn that excessive risk taking is not going to be subsidized by the government.  Most people believe in responsibility and ethical behavior.  However, it seems somewhat foolish to expect responsibility to prevail when excessive risk taking is rewarded by a government that actively manufactures moral hazard.

Running in Circles

An extremely disturbing trend has emerged lately where the Federal Reserve is directly purchasing debt from the Treasury by printing new money.  The danger from this phenomenon comes from the fact that this increase in the supply of money will eventually dilute the purchasing power of dollars currently outstanding, and that the market activities of the Federal Reserve are artificially suppressing interest rates for government debt.  (Much of this is being done to finance the current government budget deficits)

What these factors ultimately add up to is a tremendous risk that current bond holders will be impoverished by rapid price inflation from the increased supply of currency, and devaluation of their bond values when market interest rates eventually increase.  The optimal way for prudent investors to shield themselves from this risk is with fixed-rate debt that is used to finance income producing tangible assets such as rental real estate.  Under this scenario, price inflation will increase the rents and value for your property while the balance of your loan remains flat.

 

Many people spend considerable amounts of time following the news of the day, and subsequently become angry over the state of world affairs.  Most people who see problems around them are infused with a natural desire to resolve them.  Ironically, this desire to solve problems is a constant thread across both left-leaning and right-leaning people.

To many of the left-leaning persuasion, daily news brings a perpetual onslaught of human suffering that is being allowed to go unchecked and unchanged by society.  Their desire is for somebody to do something to ease this suffering.  Generally speaking, people of this persuasion would prefer to see government step into action.  The persistence of suffering is seen as justification for higher taxes and more concentration of power in the hands of government.

To many of the right-leaning persuasion, daily news brings a perpetual onslaught of government failure, corruption, and excessive power that has been allowed to continue across multiple generations.  They see the erosion of freedom from government regulations, and confiscation of resources through taxation for the purpose of empowering politicians in the name of addressing social ills that never seem to be solved.  Generally speaking, people of this persuasion would prefer to see a less active government, and an increase in free market forces.  The continued failure of government programs to achieve their goals is seen as justification for reducing the size and scope of government activity.

The unfortunate fact that people of both persuasions must ultimately come to grips with is that we do not always live in the world of how things should be . . . we live in the world of what “is”.  Put another way, there are many forces beyond our ability to individually control that shape and influence the world around us.  It is most certainly true that sometimes events will unfold in a way that is more favorable to people on the left, or the right, but it is always true that neither persuasion is every going to be fully satisfied with the tenor of local, national, or wold events.

In many cases, people allow themselves to become bitter and angry because of what feels like a persistent failure of world events to transpire in a manner that they feel is just.  In some cases this phenomenon manifests itself as an “Angry Liberal” or an “Angry Conservative”, but in almost all cases it involves people who are continually upset about a set of circumstances that they cannot control.  In this way, each successive piece of news or information that we consume becomes another piece of evidence showing how little influence we have over the world around us.

In response to this, we recommend shifting focus toward the things in life that we can control.  Put another way, we recommend to live in the world of “is” instead of the world of how things should be.  Instead of focusing on all the problems in the world, focus on what you can do to create something beneficial.  Instead of studying the news as a means of demonstrating that your anger at the world’s political leaders is justified, seek to find information that will help you take action in a way that benefits your family or those in need.

If you are concerned about human suffering, stop complaining about how the government isn’t doing enough and go do something yourself.  Volunteer for an agency who helps people in need, or donate to a charitable foundation.  if you are concerned about the pervasiveness of government, stop complaining and do something to secure the financial future of your family.  Start a small business that generates supplemental income and generates legitimate tax write-offs.  Study investments to determine which ones will provide optimal returns with reasonable risk in a tax favorable manner.

In short, living in the world of “is” really comes down to taking action.  It is not difficult find problems, or to complain about them.  It is considerably harder to actually do something about some of these problems.  However, it is considerably more rewarding as well.  This is not to say that nobody should advocate for changes to government institutions . . . on the contrary, civic participation is a key tenant of continued national prosperity.  What it means is that your future should be built on your own actions, not the actions of people in political office.

In the end, each of us is ultimately responsible for creating our own life.  To many people, this statement seems self-evident, but it is important to ensure that actions match our understanding.  There is nothing wrong with remaining hopeful for progress in the political realm, but there is power in the understanding that we direct our own destiny.  Each new day is a new opportunity to take action.  Make sure that something new is achieved with each passing day, and the future will brighten in a very fast, very profound manner.

 

With recent news overwhelmed by the financial difficulties of US state and national budget deficits, along with the continued financial difficulties in Greece, Spain, Portugal, and Italy there is a renewed focus on the impact of debt on national wellbeing.  This is especially important because most of the developed world is not far behind the major problems of these European nations.  The most important thing to understand about debt is exactly what it is, and by extension, what it is not.

Fundamentally, debt is a financial magnifying glass.  It will amplify whatever your current financial situation happens to be by the extent of your leverage.  For profitable endeavors, debt makes them more profitable by allowing the investor to expand the reach of his capital.  For example, if you can borrow $1,000,000 at 5% and earn an 8% return you would create $80,000 in returns while incurring $50,000 in expenses.  The $30,000 net profit would belong to you as the investor.  (So what’s the problem?)

But what happens if your forecasts are inaccurate?  If the same $1,000,000 that you borrowed at 5% only produces an income of 2%, you now have $20,000 of income and $50,000 of expenses.  This leaves you with $30,000 in losses.  Now let’s assume that you don’t have $30,000 available to pay for upholding your contract?  Who is going to come up with the difference?  (OK, now we see the problem)

If your name is AIG (and by extension Goldman Sachs, who was the #2 holder of AIG contracts) then the answer is simple . . . the taxpayer will pay for the debt.  However, the taxpayer does not have any money, since the government is running massive deficits.  Again, the answer is simple . . . create the money out of thin air.  In political circles, this is referred to as “quantitative easing’.

This begs the natural question of why anybody would be stupid enough to lend out to a borrower who cannot pay their bills.  The only way such an idiotic thing could happen is if a string of politicians create web of foolish laws that effectively forced the market into these bad decisions.  Only the most hardened of partisans could avoid the conclusion that rational people do not make loans of this nature unless the government steps in to assume all of the risk.  (The terms Fannie Mae and Freddie Mac should be coming to mind)

Getting back to the notion of creating pretend money, whenever the Federal Reserve ‘eases’ the money supply, it pushes more currency into circulation and devalues the currency already in the economy.  Thus, by a feat of financial magic a government that is so incompetent it cannot even pay its own bills can mystically satisfy its debts by reducing the purchasing power of every dollar in circulation throughout the economy.  This feat of financial magic is known in economic circles as ‘inflation’.

Now we come back to debt.  People who have borrowed prudently will find that inflation actually makes them wealthy by increasing the nominal value of what they own while the nominal value of what they owe to the bank remains fixed.  This phenomenon is especially powerful if the asset produces income from rents or dividends.  The most frequent example of this principal is rental property.  It is typically financed with fixed rate debt and produces rents for its owner.  As inflation rolls through the economy, its value grows, its rents grow, but the mortgage payment remains fixed.

Ultimately, what we see is that debt in and of itself is not inherently good or bad.  It is simply a magnifying glass that intensifies the current situation.  When used prudently and intelligently, it can amplify investment returns and protect investors from inflation.  When used foolishly, it can plunge a person into inescapable debt and perpetual servitude to interest payments.  When used by governments it is an implement of massive financial destruction that lays waste to entire generations for the simple purpose of satisfying the egotistical caprices of those in power who wish to be re-elected by spending public resources.

Debt has uncovered the great hubris of people, business, and government as each assumed that their ability to pay would perpetually expand.  This induced them to spend in excess of what they produced under the assumption that there would be a better future that allows them to make good on their obligations.  For some, this fictitious salvation has seemed to be achieved in the form of a ‘bailout’.  However, there is a finite limit to how many bailouts can be undertaken.  When the ability of government(s) to subsidize irresponsibility reaches its ultimate limit, the harsh side of reality will come to bear.  This reality is that many people and countries across the globe have been spending in excess of what they produce for many years.  Some have attempted to save themselves by asking their ‘rich uncle’ (frequently named Sam) to rescue them from their own idiocy.  The fundamental problem with this fantasy is that the rich uncle cannot rescue everybody.

For those of us who wish to enjoy a life of personal, professional, and financial success it should be obvious that nobody will deliver it except for ourselves.  The government can make all the promises in the world, but none of those promises can be kept without resources.  (Incidentally, attempting to defy the laws of economics by granting entitlements in the midst of deficits is akin to creating a law that declares gravity illegal.  Regardless of what a self-obsessed plutocrat writes down on a piece of paper, reality cannot be legislated away.)  The great promise of government has been little more than a great lie to lure unsuspecting fools into sheepish support of self-important politicians.

The only future that awaits is the one we create for ourselves.  The world is splitting into those who create their future and those who depend on somebody else for their well being.  The lot of those in the dependent class cannot go anywhere but down.  The prospects of those who create their own prosperity are fueled by historic opportunities that unfold on a daily basis.  The only question that lies before each of us is which path we will take.  One is easy and one requires disciplined work.  One will create economic bondage while the other creates financial freedom.  The choice is ultimately up to you.  Which path will you take?

 

Recent news of growth in the Gross Domestic product, and the appearance of home price stabilization have led many to proclaim that the economy has entered into the greatly desired ‘recovery’ that many in the government and news media are fancifully searching for.  This appraisal of the current economic situation is based on past experience with brief and shallow recessions that were immediately followed by a sharp recovery and expansion.  However, there is a fundamental difference between those events and the current situation.

The fundamentals of a market economy are based on the aggregation of many people making independent decisions.  For example, the housing market relies heavily on people buying and selling homes for liquidity . . . but this buying and selling can only take place if there are people that can legitimately afford to pay their mortgage.  The unique aspect of this recession is that it was precipitated by a massive influx of people purchasing homes who could NOT legitimately afford to pay for them.  Thus, there is a tremendous inventory of homes for sale, and a desperate shortage of people who can afford to pay for their mortgage.  Because of this, it is not reasonable to assume that any real housing recovery will occur until there is an increase in the number of people who can afford to pay their mortgage.

Similarly, there can be no real economic recovery until there is an increase in the amount of people who can afford to pay for their lifestyle.  Put another way, more people must produce enough to pay for what they consume.  Currently, a large amount of spending is being financed with private borrowing, government borrowing, or government subsidy.  None of these represents anything remotely approaching an improvement in market fundamentals.  It is simply borrowing from future production to try and create the appearance of recovery.

In the end, there will be no easy way out of this recession.  Most recessions occur because of a misalignment in market prices that cause a disruption in output.  The current situation was caused by a misalignment in basic economic fundamentals.  Furthermore, the government is actively working to prevent these fundamental from realigning, because of the short-term fallout from economic adjustment.

No Shortcut Home

It has already been established that the root cause of our current economic situation is a misalignment of market fundamentals and a shortage of people who produce enough to pay for what they consume.  In order to improve these fundamentals, three things must happen:

1. Market prices for assets such as real estate must be allowed to fall sufficient low so that they attract investors.
2. The top producers must be incentivized to create more opportunities by removing regulatory barriers and lowering taxes.
3. People whose productive capacity is sitting idle must be incentivized to go out and produce by finding employment.

The unfortunate truth is that current government policy is oriented in the exact opposite direction of the things that must happen for a fundamental recovery.  By expanding entitlements and perpetually extending unemployment benefits, the government is creating a culture of dependence by conditioning a permanent ‘underclass’ of the population who relies on subsidies for their existence.

It is certainly true that initiating a market recovery would be painful.  It will involve many people experiencing uncertainty about their financial situation and settling for much lower compensation than they have become accustomed to receiving.  It will also result in a sharp reduction in the standard of living for the people who have been living beyond their ability to produce.

However, in the long-run it will return the nation to a sustainable growth trajectory that is built on market fundamentals, instead of government subsidy and borrowing.  If this culture of debt and dependence continues, it will eventually result in massive inflation as the government turns to printing money as a last resort for financing its entitlement promises.  If this occurs, it will have the effect of permanently impoverishing the dependent class by slashing the real value of their entitlement payments and leaving them without any of the market skills that are necessary to create real output or build real wealth.

For people who are looking to escape this trap, it is critical to avoid the culture of dependence, develop the skills necessary create real value in a global marketplace, and invest in opportunities that create real wealth and place them in control of real assets.  This is what will separate the productive wealth owners from the dependent consumption class.