Thursday, June 9, 2011

The Two Parts to Debt ... One Easy, One Hard

Debt is easy to accumulate and hard to eliminate. It's as easy and as hard as that.
It's all part of the short versus long term equation or what economists label the time inconsistency problem. In the short run, going into debt by spending money that's not ours feels good. In the long run, come payback time, it's usually the kind of fun we wish we'd skipped.
Debt is a habit, and we should encourage our younger selves not to get into such a bad habit. It's easier to stay away from at the outset than to escape in the end. That's for certain.
The fact is that we have too much debt, both as individuals and as a nation, and we need to address the long term aspects of it now, so it won't get too far out of hand in the future. It's not irreparable just yet but a major effort is long past due.
First, let's generalize about how we get into debt so easily by using a straightforward explanation. Individuals as well as countries engage in financial activities which include generating income, incurring expenses, and then arriving at the resultant savings or borrowings therefrom. Savings can then be invested, while, on the other hand, borrowings represent debt along with the interest charges thereon until the debt has been repaid in full.
We create accounting reports in the form of income statements and balance sheets to tell us how we're doing financially. In brief and at the risk of oversimplification, the income statement reveals what happens to income in relation to expenses during a given period of time. If we bring in more money than we spend during that timeframe, we generate a surplus or savings. If we spend more than we bring in, however, we generate deficits and need to take on debt which is then owed to our creditors. Thus, over time, as a result of whether we spend more or less than we receive, we either accumulate savings or debts. Either is habit forming.
It really doesn't matter how much we earn or spend in absolute terms. It's the relationship of income to outgo that matters. We can always spend more than we make, regardless of our income, but we also generally can spend less than we make if we establish the habit early enough.
The balance sheet or statement of liabilities reveals the cumulative "over time" effect of savings or borrowings for each prior period unti today's date. That is, the balance sheet represents the current status of the our financial condition at a point in time which shows what's happened to the cumulative inflows and outflows over many years. An ongoing scorecard of where we stand at any point in time, if you will.
Income statements are often referred to as moving pictures and balance sheets or liability statements as photographs.
Debt is a balance sheet or liability item. It tells us what obligations we have undertaken and how much future income, over and above interest charges on the debt incurred, will need to be earned and then repaid to the creditors over time. Repayment is intended to be made possible by future earnings (income statement) and in large part from the returns on the investments made by the money spent as a result of the prior debt incurred and for which interest payments are being made.
Without going into unnecessary detail at this point, far too little attention is generally paid to the balance sheet or debt piece of the equation. Unfortunately we usually focus on the income statement piece instead. This is true whether we're looking at the behavior of individuals or for our country as a whole.
Debt represents neither more nor less than a claim on future earnings or surpluses. In addition, the interest on the debt is an ongoing "rental fee" charged for the use of the lender's money until repayment in full has occurred.
To repeat the obvious, the reason we incur debt is because we haven't saved enough or earned enough, as the case may be, to make the investment from our own funds. If in year one we earn 100 and spend 80, we save 20. But if we earn 100 and spend 120, we must borrow 20, and we incur debt. We experienced the exact same earnings in each instance, but due to different spending levels we ended up in a totally different situation with respect to the future opportunities or obligations for our family or country.

In order for us to be able to know how to manage all of these inflows and outflows properly, we must first obtain the requisite general KNOWLEDGE required to manage our financial affairs as responsible family members and informed citizens. In a free society, we simply must commit to take the time and make the effort to become knowledgeable citizens, the strongest piece of a free society. Accordingly, it's imperative that we become familiar with both the good and bad long term effects of cumulative savings and debt, as determined by annual surpluses and deficits.
As a country, we don't have so much of a short term problem as we do a long term and seemingly intractable situation. And too many people have the same problem as does our country as a whole. Knowledge is the only permanent answer. We need to know why we must take the near term, albeit perhaps somewhat painful, steps to get this debt situation under control and well on the way to a satisfactory long term resolution.

As individuals the temptation to take on debt begins early in life. We are encouraged by many to borrow for such things as student loans, credit card purchases, cars, houses and on and on. Borrowing isn't inherently bad, but if it precedes saving, it is bad, because it thereby precludes savings and investing.

In the end, it's all about habits. Both individually and as a nation. And as citizens of cities and states, too.
We'll spend some time on this "knowledge about debt" stuff in future posts. While it's obviously best to get this knowledge at a young age, it's never too late to decide to be a better informed citizen. Let's learn how to "keep it easy" together.
Thanks. Bob.

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