A mortgage specialist in California in 2008 explained why the sub-prime mortgage crash happened. It is quite obvious once you see it. Prime borrowers make payments out of cash flow. Sub-prime borrowers make some of the payments out of cash flow and the rest out of new borrowings.
As long as their ability to get new credit is not impaired, they make the payments. If they cannot get a new credit card or a limit increase the whole thing fails.
Today, Politicians cannot make the debt payments out of cash flow. The need new borrowings to make it work. Sub-prime borrower mentality.
Probably not, although I doubt they think about it much. Politicians like spending more than almost anything else. Maybe campaign contributions are better, but even those won’t help if they cannot spend. Spending is their reason for being.
Sub-prime borrowers miss an important detail. Borrowing is a kind of time machine. It extracts money from the future to apply to spending today. With interest, the extraction is larger than the immediate price. There is an inevitable settling of accounts. How are you, or the government, going to do it?
Every dollar borrowed now is a dollar that cannot be spent in the future. Does that harm the future? Sometimes.
If the borrowing is to build something of economic value, debt is positive. The cash flow from the capital pays the debt and leaves more. Without the borrowing now the cash flow in the future would not exist. Good debt.
It becomes unpleasant when the borrowing is for consumption. Then there is no new cash flow in the future to make the payments. Something must be foregone to make the payments. Bad debt.
People, including governments, must come to understand you can only spend the money once. If you want it or need it in the future, you cannot spend it now. If the debt will not pay itself off with increased earnings or cost savings, something else must come out of your budget.
Borrowing requires a cost – benefit analysis. The trick in this one though is the difference in time. The benefit is now and therefore very valuable. The cost is in the future and that is a very difficult thing to analyze. We don’t value the future very much. We think we use some sort of rational discounting technique to estimate its future cost, but we do not.
People don’t think about it but, we all use hyperbolic discounting. Under that method anything more than a year or two in the future is of no consequence. It is the distant elephant problem. An elephant, a big cost, far away looks tiny. Time brings us closer. An elephant at 100 yards is more formidable, and if unprepared, we are in trouble.
The same thing happens with savings versus spending. Value now or value later. Now is better emotionally.
Most people are a little time incompetent. Some dwell on the past. Others have high hopes for the future. The present should be the focal point. Some of us are completely time incompetent. Once you know the tendency you can overcome it.
Politicians don’t fear debt because they pay no price to make bad borrowings. You don’t have that luxury.
Be a little more patient. If the debt doesn’t provide income or cost savings, be very careful. If you could not save the payment you are committing to now, you cannot afford the payment without the income or the cost saving.
Be obsessive about analyzing debt that will return no income or cost saving, but will acquire an asset that appreciates. That decision has risk. Even if it does appreciate, can you turn it into cash to make the payments. Appreciation investments always have a liquidity risk most people ignore.
Paying down debt is a riskless investment, often with a high after-tax yield. The risk was in what you bought with the borrowed money. Keeping debt can add risk if it is renegotiable in the future. What happens if your mortgage interest rate changes from 2% to 7%.
Debt management should begin before you borrow. Get in the habit.
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