Fiscally Fit: A check-up for your financial fitness
1) When is debt good?
a. When I feel like spending money
b. When I am buying something that I can see & touch
c. When I am buying something like a house or car
d. When I am buying an asset that produces income
2) When is debt bad?
a. When it causes you to be highly leveraged on an investment
b. When it is used to finance consumption
c. When you use your credit card
d. Debt is always bad
3) What causes inflation?
a. Evil businesses raising prices on the little guy
b. The federal reserve increasing the supply of available money
c. OPEC constricting output to push-up prices
d. A tri-lateral conspiracy between George Bush, The Illuminati, and the Vanderbilt Family
4) What is the result of inflation?
a. It destroys the value of savings, equity, and debt
b. It creates jobs by increasing the amount of money in peoples pockets
c. It makes me more wealthy by increasing the value of my house
d. It makes me more wealthy by increasing the value of my 401k
5) What happens when the government increases spending?
a. It means that I get free money in my mailbox
b. It means that those rich people will finally have to pay their fair share
c. It means that the government must extract more resources from the private economy through taxes, borrowing, and inflation.
d. It means that the country starts to run better, because the government always does things more efficiently than the private market.
Answers: 1) d, 2) b, 3) b, 4) a, 5) c
Explanation of Answers:
1) When is debt good?
The way that debt can work to your benefit is if it is used to finance an income producing asset that pays your interest costs. The most typical example of this is rental real estate. As the owner, you take out a fixed-rate loan on the house, the tenant pays you rent, and you pay the applicable tax, insurance, and mortgage expenses.
Over time, inflation will increase the value of the house and the rents paid by your tenant. However, the amount you owe on the house will stay flat because of the fixed-rate debt. This will result in your profits increasing.
2) When is debt bad?
Generally speaking, debt will work against you when it is used to purchase anything that doesn’t produce income. The reason for this is because the interest for debt that is used to make these purchases must be paid out of your income. Furthermore, as the amount of debt goes up, it consumes more and more of your income. By concentrating debt in assets that produce income, you can escape this ‘debt spiral’ trap that keep many people confined in financial prison.
3) What causes inflation?
As tempting as conspiracy theories can be, the money supply is the principal factor that drives inflation for the overall economy. Supply and demand can create price spikes and drops in specific products like oil or corn, but the only way to make everything more expensive at the same time is to increase the amount of money in circulation while the amounts of goods and services stays flat or decreases. This phenomenon is known as ‘more money chasing less goods.’
4) What is the result of inflation?
Inflation erodes the purchasing power of all things that are denominated in dollars. When the prices of everything you buy go up, but your savings account only grows at 0.2% per year it results in a negative ‘real’ rate of return since the savings will now buy less than it did before. In practical terms, this means that dollar-denominated assets like home equity, savings, and CD’s along with liabilities like debt will all have their value destroyed by inflation. Because of this, the optimal strategy is to have your assets denominated in physical things and your liabilities denominated in dollar-based debt.
5) What happens when the government increases spending?
The government does not have the capacity to produce anything. The only way that it can spend anything is to first take it from somebody else. Sometimes this is done directly through taxes, and other times it is done indirectly through borrowing or inflation. The way that borrowing takes money is by displacing private debt with government borrowing, effectively reducing the amount of capital available. The way that inflation takes money is by eroding the purchasing power of people’s salary, savings, and home equity to finance government spending.
Because of this phenomenon, it logically follows that any time the government decides to do something that the private sector could do more effectively; it drags down the overall economy by displacing private economic activity. (Granted, the government frequently enacts arbitrary laws & regulations that artificially hamper the efficiency of private industry, thereby creating a perception that the private market is broken, when the problems are all a direct result of government fiat.) The adverse incentives implicit in this balance is that politicians derive their power from the amount of money that government spends. Because of this, politicians have an incentive to make government bigger, regardless of how much it erodes the economy because it will result in them becoming more powerful and important.
The Solomon Success Team
Flickr / Tambako the Jaguar