Sunday, July 10, 2011

The Golden Rule of Finance

There is one Golden Rule to successful personal finance.  Spend less than you earn.  When struggling financially, there are two sides to that equation you can work with.  Either you attempt to modify your earnings (aka: sell things, get another job, get a new job, or just plain get a job).  Or you can modify your expenses (consolidate debt for lower interest, cut unnecessary bills, reduce discretionary spending, move someplace cheaper, cut coupons, etc).  You can earn less than you spend and survive, but not for very long.  Debt will bury you.

Of course we violate this rule all the time, and sometimes it works out okay.  But never for long.  Maybe you take out student loans to go to school.  Assuming you get a job that increases the earning side of the equation, you can pay that back and eventually come out ahead.  Maybe what you earn in the month of December is less than what you spend for Christmas.  Assuming you saved a little during the other 11 months, you can usually afford to do this.  Maybe you buy a house that you could afford at the time, but then lose your job or change jobs and suddenly earn less.  Assuming you have enough savings cushion, you might still be able to make your payments.  But maybe you'll have to move someplace cheaper.

There's one other piece of this puzzle I've not touched on fully.  It bears mentioning that the Golden Rule of Finance has a Silver Sidekick.  As much as you can, plan for the future.  This means you need your earnings to exceed your spending enough that you can save the excess.  Incurring debt by borrowing makes certain assumptions about the future.  Namely that what you want to have now is important enough that you'll commit to future repayment.  But the future is often unpredictable, and debt repayment has a way of highlighting that like nothing else.

Now, you can occasionally find yourself out of balance with the Golden Rule of Finance and still be okay.  The road of life is full of bumps and twists and unexpected turns.  But when trouble comes, it's how we react to it that matters.  Do we recognize the road we're on?  Do we see the imbalance when it's there or predict a future imbalance?  Are we willing to make sacrifices to modify the equation?  That last question is key, because if you find that you spend more than you earn, you cannot modify the equation without sacrifice.  Sometimes difficult.  Usually painful.  Often realized late.

That's where our nation finds itself with this debate on the debt ceiling.  The same simple equation for personal finance applies here, just on a much grander scale.  The trouble is, the federal government's earning side of the equation is not normal.  They don't earn money as much as take it or make it.  They take it via taxes.  They make it either literally via a printing press, or artificially via methods like quantitative easing.  Taking money via taxes stymies growth in the private sector by reducing consumer spending, or by affecting unemployment.  Which is a bigger problem as many taxes are tied intimately to employment.  As unemployment rises the earning side of the equation suffers further.  Making money contributes heavily to inflation.  Interestingly, inflation is somewhat good for debt because the money we borrowed in the past was more valuable than the future money we use to pay the debt back.  Of course, in every other way inflation comes at a heavy price quite literally, as future buying power is reduced.

The US has committed to spending more than it earns on all the things the government spends money on.  And borrowing to do it.  And that course is not sustainable, and that's what the current debate in congress is about.  It's not politically viable to make the sacrifices necessary to balance the equation.  Raising taxes is not popular and is potentially job killing during a time when 'economic recovery' is tenuous at best.  Cutting spending is not politically viable either as there is always some advocate on the receiving end of those benefits that will make a fuss.  Of course, the worst thing we could do is just borrow again and not change either side of the equation.  Raising the debt ceiling means that we'll just continue the borrowing cycle, which only ends one of two ways - eventual repayment (sacrifice) or eventual default (greater sacrifice).

Nancy Pelosi recently asked why the vote on raising the debt ceiling couldn't be decoupled from the vote on spending.  The question is so alarming because it shows how ignorant those at the helm are to the situation we're facing.  I recently read somewhere where someone posted that this is like a fat man gearing up to eat a trillion more donuts before promising to finally diet.  Politics are going to have to be put aside, and possibly political careers as well, and both sides of the equation are going to have to be modified if calamity is to be avoided.

Ultimately though, the sacrifice will happen.  If not in this generation, then I fear the next will be forced to pay it.  And by then the sacrifice will have accrued interest.