Debt and delusion do not equal prosperity
By Christopher Galakoutis
Wednesday, November 23 2005 12:01 AM

When I was studying Finance in the 1980’s, two of the most obvious rules in the book of financial planning were to pay yourself first and then pay down your debts.

However in today's headlines we read the following:  "If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years."  So says David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?"  Lereah added that such fiscal conservatism is in fact "very unsophisticated." 

The implied flipside is that the exercise of prudence has in fact been foolish, begging the following question: Have our degrees become barbarous relics destined for the scrapheap of history?

Current psychology is a product of environment.  Environments are not static but swing back and forth in waves that can last many years, hitting extremes on either end of the spectrum.  Ever since the generation that endured the depression and WWII, no subsequent era has dispensed commensurate pain or hardship.  Instead, the generations that followed have ridden a long wave of prosperity that many believe will never end and is a God given right.  Is it any wonder then, that statements like those of Mr. Lereah are given credibility by mainstream media and presented as expert advice? 

Alas, such is the state of affairs in the US today.  Total household, corporate and government debt now exceeds 40 trillion dollars, not including unfunded employee pension, social security and medicare liabilities.  These debt levels are unprecedented in world history.  Household debt alone exceeds 10 trillion, as US consumers have apparently concluded that what is good for the goose is good for the gander.  Financial institutions and their lax lending standards -- with a green light from the US Federal Reserve -- have contributed to these huge numbers, offering credit to virtually anyone, with little regard to qualification. 

Let’s look at an example.  A promising young athlete earns greater sums of cash because the contracts he signs keep increasing.  Despite excessive spending and borrowing to support his lavish lifestyle of multiple cars and homes, his paychecks and endless supply of credit finance his expensive tastes.  After all, his creditors have no reason to worry because he represents the epitome of success.  But let’s fast-forward to the end of his career.  With a declining salary but a continued need to spend, he refinances his homes to cash out any appreciation, hits spending limits on his credit cards, raids his retirement and investment accounts as well as the kids’ college funds and borrows money from family and friends. 

Aside from the downward spiraling spectacle, red flags would surround this individual in a different environment, whereas today, bank credit would remain available.  One reason is that these loans, and their underlying risks, are repackaged into financial products and sold off.  They end up as assets on unsuspecting foreign balance sheets, underscoring the dangers to the world financial system if debtors are unable to pay.

On a trip to China last October, US Treasury Secretary John Snow met with Chinese officials to discuss, one would think, these and other troubling issues.  Instead, Mr. Snow suggested that the Chinese should spend more and save less, and advised on how to replicate the great US prosperity story.  Chinese leaders, who have warned of US imbalances and the need for the US to get it’s own house in order, may not have agreed with Mr. Snow, and, may even have found his advice quite amusing.  Of course, with China’s financial health riding on their billions of dollars of US investments, I would concede that humor might not have been the first emotion they experienced. 

In fact, the 2500 year old wisdom of Sun Tzu’s great work "The Art of War" may have come to mind, where the Chinese master stated that "invincibility lies in the defense; the possibility of victory in the attack."  Well aware that paper assets denominated in a fiat currency have no intrinsic value, only a perceived one, and that perception can change in an instant, China’s leaders may in fact be thinking along different lines, notwithstanding US advice to the contrary.  After all, if we were to turn logic on its head to validate any absurdity -- like spend more, save less and prosper -- we could also send the debt-riddled Montreal 1976 Olympics delegation to meet with Beijing 2008, and advise that the key to profitability is disregarding cost controls. 

The world recognizes that risks to the financial system abound; the gold price increasing in all currencies is signaling as much.  But when officials in government talk about economic risks being effectively managed and the remarkable resilience of the US banking system, it is easy to see how the relative calm of the last few years might be inspiring a false sense of security, and even outright invincibility here in the US.  This "condition" would be analogous to the driver who speeds through a red light at a busy intersection, bragging that he hasn't been in a collision and willing to wager that he never will.  Would anyone with an IQ above room temperature want to join his side on that wager?

In fact, a terrible accident would occur at some point.  Similarly, the prosperity wave that debt built could come crashing down at any time, as ever-increasing debt levels are simply unsustainable.  At a time when prudence has been abandoned in search of the good life, it is important to remember that global financial conditions can change at lightning quick speeds and have a cascading, cross-border effect.  There is still time for individuals, as well as governments, to arrange their affairs and protect themselves and their loved ones.  A good start might be dusting off that old Finance text, and adhering to the "very unsophisticated" concepts therein.  For, a timeless wisdom applies today: forewarned is forearmed.

Originally published in Metohos Magazine's Jan/Feb 2006 issue

© 2005 Christopher G. Galakoutis

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