Should you help your children stay out of debt?

“In my day if we earned a quarter, we spent 15 cents and saved a dime. Your generation earns a quarter, spends the quarter and then borrows another quarter at 25% interest!”

I really identified with that saying by Jeanette Pavini in Market Watch. Wondering why it spoke to me so profoundly, I drilled deeper and came to the following conclusions:

  1. The thought processes are totally different between generations. When I was a kid, the concept still existed, that you can spend only what you have and no more. I would receive an allowance each week, but only after I showed the balance, and how the difference with last week was spent. It was not a matter of “checking up on me” as to how I spent my money and whether is was done wisely. My dad never evaluated the wisdom of my decisions, only the record keeping: that my physical amount of money matched my records. To give an example: A 10-year-old’s version of “living within one’s means” might include financial decisions like choosing whether to buy a new video game or saving their money so they can eat at the concession stand with their friends at the next field trip.
  2. Today’s generation is taught that you can have it all now. To sweeten the deal, the idea is that you pay-for-it-as-you-go, enjoying both your new video-game and a good time with your friends. This concept is permeated throughout our society: with lower interest rates you refinance your house, as your family grows you purchase your next bigger house, when you get a loan the payment plan conveniently shows the “minimum payment” (because the longer you draw out the payment the more interest your friendly banker makes!). Immediate gratification comes with a price, but “oh well, the house price will go up anyway, right?”

“Our financial habits rub off on our children and influence their relationship with money later in life. But what may be surprising is just how young children start to form financial habits. Adult money habits are set by the age of seven, according to a study by behavior experts at Cambridge University and published by Money Saving Advice.

Many children are growing up in debt-ridden households. As of September 2014, the average household owed $7,281 on their credit cards, according to NerdWallet.com’s analysis of Federal Reserve statistics. Looking at just indebted households, that number rises to $15,607 in average credit card debt per household. That’s a collective $880.5 billion in credit card debt that American consumers owe.” (from an article by: Jeanette Pavini’s Buyer Beware, in Market Watch).

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Bob Parrish 10 days ago:

       I got my first credit card at 18, a BankAmericaCard, the precursor of Visa.  I started using it for everything…and still do a half-century later!  But I NEVER carry a balance, instead using credit cards for the float they offer, for tracking my expenses, for frequent flyer miles, for enabling car rentals and hotel stays, etc.

Credit cards aren’t the enemy.  DEBT is the enemy and credit cards that are paid in full each month don’t generate debt.

PRINCIPLE I  about NATIONAL DEBT:

Teach your children the difference between (National) Debt and cultural habits. 

The Business Cycle

Business cycle sounds very educational or professional, but is really an everyday concept. Imagine that the population of a country increases over time, which is the case for many countries in the world, that technology makes it possible to produce widgets more efficient, and that new inventions reduce the cost of production. This happens in many western countries today and in many non-western countries as well. As a result the GDP will increase over time, but not in a straight line. There are many ups and downs and these are not the same each time. Sometimes GDP will increase for a longer period of time than other times, or the other way around.

We can graph that as follows, according to another lesson of the Kahn Academy:

business cycle

On the vertical side we have the real GDP and the horizontal line expresses time. Assume population is growing and productivity goes up because of technology, the discovery of new resources, and the development of new processes. This results in an up going slope of GDP over the long run. In the short run we see ups and downs around this graph. The ups and downs are not as evenly spread as shown in the graph, but it gives the idea. In the short run we see expansions when things are going well and recessions when not so well. During an expansion more jobs are needed, people will buy more because they feel the economy is doing well, and more will be produced to meet that demand.

There comes a time when producers find themselves stuck with a bigger inventory, or they are using their equipment to the limit and cutting corners on repairs. They hire more people than are really needed. This results in a smaller profit and manufacturers will start scaling back. Everyone is still optimistic that it is only temporary or only affects some businesses. Even economists remain optimistic. But as it continues, people get a bit nervous. The standard saying applies here: “If my neighbor loses his job it is a recession, but when I lose my job it is a big depression.” Things start to improve and gradually people become more optimistic again. Then we get to the top and a new cycle starts. Not all cycles are the same. We saw this with the 2009-2010 recession, which was at its lowest point since the Great Depression in 1933. Currently, there are more job openings, gas prices are going down, but incomes still remain level so not everyone is convinced yet that the economy is improving.

1950-2014 GDP

Here is the real graph showing how GDP has been growing since 1950, but this is a “sanitized graph” not showing the ups and downs. It is interesting to see the 2008-09 recession as just a “blip” in the overall picture. Below are the details of National Debt:

Screen Shot 2014-11-13 at 2.47.53 PM

 

Screen Shot 2014-11-13 at 2.48.23 PM

Note how under Clinton the National Debt only increased 3.9 %, but the trend started under the old Bush!

What makes it a bit more complicated is when the government artificially lowers the interest rate, as it is doing now.

 The basic story is that when the government artificially lowers the interest rate, it gives the appearance of the prosperity that would accompany a genuine influx of new savings, but this apparent prosperity can’t be genuine since it is fueled by nothing more than pieces of paper (fiat money) . 

Technically, it’s not correct to say that the economy can finance an increase in output of both consumption and capital goods, by ignoring depreciation . this is because the way the economy deals with depreciation is to produce more capital goods . For example, if a particular entrepreneur engages in maintenance on his factory by buying ball bearings and lubrication oil, and by slowly building up a new machine to replace his current one once it wears out, then these actions are all acts of investment in the creation of new capital goods , so really what happens during the unsustainable boom period is that entrepreneurs produce the “wrong” kinds of capital goods, and yet they erroneously think that their total output has increased .  (from: Lessons for the Young Economist, Robert P. Murphey)

Since the government is keeping interest rates artificially low it appears we are in such a situation.  How long will this last?

Aggregate Demand and Foreign Exchange

One more component for aggregate demand is foreign exchange. Let’s look at another screenshot from the lesson of the Kahn Academy:

Screen Shot 2014-11-02 at 5.08.01 PM

Look at the three bar graphs in green and purple in the top left. The middle graph reflects the amount of GDP spent in green and the purple represents investments. If price goes down (upper bar graph) there is more available for investments, assuming everything else remains equal. Thus, the interest rate can drop. When the interest rate drops it is / can be advantageous for a foreign country to invest and / or purchase from you, rather than produce it themselves.

Say the exchange rate starts out with $10,000 = ⎳5,000 (British pounds). When the exchange rate drops because Americans have more to invest, let’s say it becomes $10,000 = ⎳4,000. It will become cheaper for the British to purchase an American good. In other words, the $ becomes weaker.

Should American companies move their banking overseas when it is economically more advantageous?

Aggregate Demand

Economists love to use formulas, which are often preceded by: “Everything being equal,…” which it rarely is in the real world. Trying to explain aggregate demand is one such formula, but it helped me understand this macro-economic concept better. I took a screen shot from the Kahn Academy course, shown below and will explain it some more. In the coming blogs I will expand on it with the objective of showing its function as a basis for understanding where the national debt fits in.

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The graph in the diagram above shows “P” on the vertical side, which stands for “price”, meaning the aggregate price of all production combined in some form. The horizontal line represents real GDP, which is the aggregate of all production of the country. (Go back a few blogs and you can find the explanation of GDP.) The diagonal line represents what the economist wants to express mathematically: that, everything else remaining equal,  if the price goes up GDP will reduce, because the consumer cannot afford the same amount of goods and services at the higher price.

The author talks about the “wealth effect” meaning that if the price goes up, there is less money a person can invest which in turn results in higher interest rates to the “renter” of that money for increasing their production. If the overall price of the aggregate goods and services goes down, the consumer will have more money available to invest and the interest rate will drop.

In last thursday’s (Oct.30) USA TODAY, there was an article about: Fed’s stimulus era comes to an end. It explained how the entire stock market (Wilshire 5000 Index) had responded to the quantitative easing (QE) to push more money into the economy since the 2008 financial crisis and the Great Recession. In other words, not everything remained equal, and the government artificially kept the interest rate low, hoping that people would buy more without the prices really dropping. In 2008, the Fed had already pushed the interest rate to zero. To stimulate the economy (increase GDP), it began quantitative easing by buying up long-term Treasury and mortgage-backed securities. In doing so the Fed reasoned, it would push long-term rates down.

More about aggregate demand, aggregate supply, and short-term and long-term supply in the  blogs to follow.

Do you understand  Quantitative Easing? I did not!