Commentary: Providing New Congress with the Greatest Power

Lead Author: Dr. Jeff Howe

Publish date: 10.31.2006


It would seem remiss if we were to completely ignore the election this month. With all those new bright sunny faces arriving in Congress, certainly there is reason to expect some change. From my perspective, there is also an irresistible opportunity to comment and provide advice. So what words of advice would I give them if they were listening? Actually, that's easy; I'd just say “it's the economy, stupid.”


In the last one hundred years the government has changed dramatically, in key and subtle ways. The result is we have a highly controlled free market system. Government programs influence virtually every aspect of our economy, whether it is through subsidies, taxes, quotas or other policy tools. Interestingly, these influences are often only apparent when domestic economic policy and trade patterns are contrasted to those of other countries. An important difference in the U.S. is the ability to easily borrow money to purchase consumer goods using credit cards and various types of consumer loans.


In fact, over the past twenty years it has become common for loans to be issued, based on the equity value in houses, to finance everything from home remodeling to purchase of consumer goods. Some individuals have even been able to borrow up to 125 percent of the value of their homes for these purposes. The government not only does not prohibit these practices, as is true in some countries, but actually supports borrowing to increase consumption and even subsidizes such borrowing, if unintentionally, through the tax system.


But aren't consumer loans good for the economy? Only if you believe that “consumption” is a key to a strong economy!


It wasn't that long ago that savings and investment were considered the key factors that the government would try to stimulate. When was the last time we even heard the national savings rate discussed on a political program or debate? Perhaps we just gave up, because the rate is so low – and because we seem to be doing well on someone else's money. And, wouldn't people stop buying stuff if they didn't have easy access to consumer loans? Well if you look at much of Europe, where consumer debt levels are much lower, that isn't true. What actually happens is that people do indeed buy less quantity, but higher quality and in many cases very different types of products. Why is this true?


To explore this question, let's be a bit more specific. As an example, a corollary question that often arises is “how can people in European countries afford to buy the Mercedes, BMWs, and Audi's that they seem to prefer, without incurring high consumer debt?” The first response is obvious: family units have fewer cars than their compatriots in the U.S. Thus they rely more heavily on public transportation, dominantly trains and buses. But the other influences are critical as well.


Imagine that you have to use your own money, and not borrowed funds, to buy a car, how would you go about it? A fundamental change in your approach to this kind of purchase might lie in how you look at a car, and the features that it should have.


Thus, if you use your own money to buy a used car, and you hope to buy a better car someday, then you might prefer to buy something that depreciates at the slowest rate possible, or even holds its value, and preserves as much of your precious personal investment as possible. As a result, factors like durability, reliability, and cost of repair may take precedence over other factors like a fancy radio and a nifty paint job. Interestingly, cars with that first list of traits tend to include used Mercedes, Volvos, and BMWs.


So just imagine that a young college graduate uses $5000 to buy a good used car, one that she can expect will hold at least 50-60% of its value in the coming four years. Then that individual puts a couple hundred dollars (or Euros) in the bank every month for the next four years. In four years she finds that she has a car worth $2,500-$3,000 and about $11-$12,000 in savings for her car. Following her success in the past, she does the same thing again, buying a good, used, high quality car that will maintain at least 50 percent of its value in the succeeding four years. Thus she spends $14-15,000 on her “new” used car and puts $200 per month in the bank for the next car. Thus in four years she again has a good car worth $7-$8,000 and $11-$12,000 in the bank after savings interest is earned. At this point she buys a two year old Mercedes for $19-$20,000 and continues her program. She now owns a car worth about $20,000 free and clear, and has spent a total of $5,000 plus $9,600, plus $9,600, or $24,200 over the previous eight years to get there.


Let's contrast this with a program based on borrowed money.


Again the individual has $5,000 in cash and can afford $200 per month. So instead of buying a $5,000 car that person buys a car for $12,500, borrowing $7,500 over four years to keep the monthly payment at about $200 (remember, in this case the interest is an expense rather than an income). In this case also, the motivations may be different since it is mostly someone else's money. Thus the concerns about the vehicle as an investment are often minimized in favor of other more pressing factors such as performance and, maybe, a spoiler and racing stripes. In four years that car is likely to be worth about $5-$6,000. So it is traded in, and another loan is undertaken at $200 per month. Thus, the person can afford – about the same car again! And inflation has made that car cost more. But even if you are optimistic and the car is worth $6,250 or 50% of the purchase price you can quickly see the difference made through savings versus borrowing. Just for completeness, let's carry the example out, and imagine that a best case scenario occurs and the car is worth 60% of its purchase price after four years. So the individual takes the $7,500 from the sale of the first car and borrows $7,500 again for four years, and purchases a $15,000 car and pays $200 per month. Four years later that individual will have, at best, a car worth $9,000 and nothing in the bank.


Contrast that with the first person, who has a car of much higher value, and about $11,000 in the bank to go with it. Quite a difference! If you carry this example out over a lifetime the differences expand almost exponentially.


Starting off by saving first versus borrowing, the individual is always utilizing interest as a benefit instead of incurring interest as a detriment. When asked what the most powerful force in the universe was, Einstein replied “compound interest.” This is especially true when the power of compounding interest is used in polar opposite directions.


So, thinking as a government, which approach should public policy promote: borrowing or investing?


As new individuals begin their terms of office in Congress, it is important to remember that Iraq is not the only job they are there for. Today we shrug off a trillion dollar debt as though it were nothing. We have compounding interest working against us, instead of to our benefit, and an increasing percentage of our taxes going toward simply paying the interest on that debt.


The Republicans argue that we already spend too much on government, and the Democrats argue that there are programs still needed that are critical to the people of this country, e.g. health care. The truth is both are correct. Without a debt we could not only at least conceptually decrease taxes but also increase programs, and perhaps even begin putting a little away for that next… bridge, airport, or space shuttle. The first step is getting a Congress that thinks less like a business focused on growth, and more like an investor focused on value.


How can we develop the most equity in terms of infrastructure (schools, highways, airports, and healthy, well-educated citizens) in the next 50 years? The key is in getting back to where we can begin the habit of living within our means, and putting a little away for a rainy day. The first step is to get our Congress to realize the power of compound interest.


Dr. Jeff Howe

November 2006