Economics for Dummies…And Liberals

Originally posted on October 22, 2011 but re-posted in honor of the fiscal cliff. Still true and the math is just this simple.

People say that government can’t be run like a business. I guess that depends on what the true objectives are. Businesses can’t chase every opportunity or customer and they can’t provide every service or product or they will fail. When viewed in this light, business does have a lot in common with government. I think that is why the Founders gave us the Declaration and the Constitution (and made it changeable, but after a long and thoughtful process). If I look at the Declaration of Independence and the Constitution, I would compare them to a business’ statement of core values (the Declaration) and a mission statement (the Constitution).

Sort of like the old analogy, “when the only tool you have is a hammer, everything looks like a nail”, I tend to see everything in the perspective of a business. I think that when people say that government isn’t a business, they mean that government can’t be run to make a profit because its mission includes social and political goals that are moral rather than driven by profit. I can see that point but I also believe that a government can be run with the goals of being efficient and eliminating waste while achieving that mission. Most businesses have been subjected to times where they have had to be managed to a breakeven point or simply to minimize a loss.

Let’s look at the financial aspects, costs first. All businesses have costs, some are used or consumed in the production of a good or service, and these are called variable costs. Examples would be direct labor or materials – the more you produce, the more these grow and vice versa. They rise and fall with the level of economic activity. These are the easiest to manage as they are determined by the economic activity in the short term and you just kind of roll with the flow. These are passed on the buyer in the form of price of the particular good or service.

The second type of cost is termed “fixed” cost, these are the costs that do not change as activity changes, and they stay constant. These are investments in long term items such as indirect labor (engineers and knowledge workers), or in the old days were termed as PP&E – plant, property and equipment. Even if you buy these outright, there is a non-cash depreciation expense that hits your books every month. These are expensed that have to be amortized or allocated in some method to the product so that they can be recovered in the sale of the product. They do not vary with economic activity – until the asset is off the books, the company pays for it whether the market is good or bad. In the business world, it is commonly referred to as “burden” – a weight that the firm has to support.

A recipe for disaster is created when a firm cannot generate enough activity to overcome the burden they already have or invests too lavishly in plant, property and equipment, creating more costs to cover. In absence of sufficient revenue, firms borrow money to operate (this includes selling more stock – this is just borrowing from an owner instead of a financial institution), called working capital, until they either retire the debt or it is clear that they business model has failed and then they become insolvent, leading to bankruptcy and often closure.

Now let’s talk revenue. Revenue is generated by the sale of a good or service. I said that businesses cannot be successful chasing everything and that is true. Opportunities have to be measured against the cost to the business and even in most businesses; capital (money) is limited. You only have so much cash, only so much credit and that limits what a company can do – but the most important part is deciding what the company SHOULD do. That is where the mission statement comes in. It is important for the leaders of the company to express what the mission of the company is and that it fits the constraints of the market and the firm’s capability and available finances.

The basic equations are simple:

  • Revenue – (Variable Cost + Fixed Cost) = Profit

And

  • Assets =Liabilities + Stockholders Equity

If I look at our country, I see it as a business. The variable costs are the costs that we incur as citizens to carry out our daily lives. Food, clothing, shelter and recreation are the variable costs. We can vary them as we please and as they fit our own economic circumstances.  Personal debt is also a variable cost – we can take on as many units of debt as we are comfortable with and our cash flows allow, but these are still truly situational – largely variable, as it were – based on choice and circumstance.

The fixed cost in our national economy is the government. It is the infrastructure, the programs and the government employees and the elected officials that work there.

During periods of economic instability, businesses delay hiring, purchase of capital equipment and expansions to avoid fixed costs that revenue may not cover – they economize, cut costs and curtail expenditures and borrowing. They cut out waste – they contract. Our government doesn’t operate that way – in the best cases, spending and government growth stays flat, worst case it continues to grow and add costs that the system must be burdened with.

Why does this happen? It happens because we base the cost of government on what we WANT to accomplish, not what we can afford to accomplish and we refuse to put limits on government in a manner consistent with the mission statement – the Constitution.  In my lifetime, I have never seen government reduced from a total cost perspective. We saw deficits and debt skyrocket under Bush, and then go into orbit with Obama.

It also happens because we have become comfortable with the prospect of borrowing without limit, printing more paper money or believing that there is no limit to the ability to tax (whether through new taxes or “fees” or via increases in the current structure).  It appears to me that we will soon reach a limit on all three of these and will have to address the fixed cost side of the equation. For many on the government payroll or in government programs, this adjustment will be rapid and painful.

Here are the three issues:

Borrowing without limit: Even nations have credit ratings and credit limits. Our borrowing consists of Treasury securities that are sold at auction. Many people don’t know this but the face value of these securities come in standard denominations and do not change – the way the interest rate is determined is by the yield, or the difference between the face value and what a buyer is willing to pay – but there comes a point when the yield curve intersects the risk curve and buyers stop buying – remember junk bonds? Hear a lot about them now? The reason that you don’t is that, for the most part, the risk was not worth assuming at any price. We just saw this with Greece – no state in the EU was initially willing to loan them anything because the risk of repayment was too great. The IMF wouldn’t even tough them and the IMF loans to Zimbabwe… that is how bad it was.

We are close to that point; the US Treasury has actually cancelled auctions because there were no buyers. Before 2010, that had never happened.

Printing more paper money: Our paper currency is not backed by gold or silver. If you look at the paper money in your pocket, you won’t see the statement “gold certificate” or “silver certificate” – I actually have a $20 “silver certificate” bill – this means that if I took it to a bank prior to 1968, they were supposed to be required to give me $20 worth of actual silver coins. Our modern money is secured not by hard assets but “the full faith and credit of the United States of America”. Look at your money like you would a stock. The second equation above comes into play – if total assets stay the same and more money (stock) is printed then each bill is worth less. By the same token, if assets don’t increase but debt does – the slice of stockholder’s equity (your money) goes down in value – same quantity of stock (money) in circulation, just worth less. This is how inflation starts – why your $10 bill doesn’t buy quite as much as it did last year. If debt increases and you print more money at the same time you get a double whammy – hyperinflation. This is why people get worked up about an 800 billion dollar (borrowed) stimulus program that generates no net increase in assets and we print money to “pay“ for it.

Taxes: Taxes have long been seen by our politicians as a limitless supply of cash. Just “soak the rich” is the populist cry. I would argue that it is far from a limitless credit card. What I am seeing with the genesis of the Tea Party movement and also just in casual conversation is a growing discomfort with paying for waste. I know a lot of people, some Progressives as well, who are beginning to grumble about the earmarks, the boondoggles and the waste in the system. I have a conservative friend, a doctor, who has told me that he would support a single payer health care plan if he was confident that the waste and inefficiency that he sees in his Medicare practice could be eliminated.

Taxes are not unlimited. We are approaching a level of futility in the people who pay the bulk of tax that will soon lead to the moral question of “why should I keep paying in a system that wastes my money and instead of eliminating the waste, just demands more?”

So what do we do? We get back to the core values and the mission statement and reign in a body politic who treats this great nation as their personal piggy bank. We elect representatives who have experience in fiscal discipline and responsibility. We don’t need Harvard trained theoretical economists for this – the guy who runs the local Jiffy lube, the store manager at Wal-Mart or the guy who runs his own landscaping business understands these basic principles better than theoretical economists because the little guy has to write the checks.

A government of citizens, not a government of elitists.

About these ads

3 thoughts on “Economics for Dummies…And Liberals

  1. Get your donations out today, for come Jan. 1, you will not be able to claim charitable deductions any longer. There’s a going to be a major hit to the $300 billion/year non-profit market.

    The poor always suffer when administrations play class warfare. They always have, they always will.

  2. Pingback: Economics for Dummies…and Liberals | Two Heads are Better Than One

Talk Amongst Yourselves:

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s