Austerity?

Money in the economy needs to come from somewhere.

The desirable source would be productive economic activity. Governments don’t produce anything. They may help economic activity through defense spending (or spending in any other activity). However, the old-Soviet Union style focus on defense may serve as a case study that spending too much in one area leads to money not available for other areas. So this point gets to the argument about what  government should focus on (not the topic of this blog by the way).

Taking a lesson from “Economics in One Lesson” by Henry Hazlitt that essentially states that money (government or otherwise) needs to come from somewhere in order to be spent someplace else. Thus, business activity (trade of products or services) generates economic activity that can be measured. Business activity can be expanded through debt. However, that money needs to come from somewhere too. Where from? Lenders and investors lending money with the intent of receiving it back. The odds of them getting their money back is represented by risk through the interest rate they charge. A high rate of interest represents the concept that this borrower is riskier than another borrower able to obtain a lower rate of interest on their loan.

Therefore, when governments want to borrow to grow the economy, what they really are trying to do is get the economy back to what it used to be. But what happens if that level of economic activity is not to be for some time to come? Why might this be so? Because the old level of economic activity was based on leverage to begin with and really represented an economic expansion based on debt instead of relying upon sound business principles.

Today business, and consumers, are going back to the basics and evaluating business opportunity or consumer consumption more pragmatically with a pragmatic eye on reality through current cash flow and incomes instead of leveraging these through the risk of taking on debt and possibly not having the future cash flow or income to repay it. Businesses are the first to adjust their budgets (people get laid off, etc., to cut expenses projected to exceed revenue). Consumers adjust quickly as well when they see what happens to others and are fearful it may also happen to them.

Governments are the last to adjust, if they ever do. Government wants higher economic growth rates because their earlier budget and expenditures were based on those prior revenues coming in.  But those revenues don’t come in. To keep spending the old budget amounts requires borrowing more. They blame the slow down on lack of government spending when it really is a more realistic economic outlook based on un-leveraged (not borrowing to expand) expectations and actions on the part of business and consumers. Indeed, consumers switch to paying off their debts and business looks to recapitalize too.

Therefore, it may be possible that the economic slowdown in Europe is a result of trying to sustain a system of payments from the government to people based on revenues that were already based on borrowing in the first place. When the revenues went down because business and consumers decided they had enough debt, this widened the budget deficits of governments even more and increased the sovereign debt. Government wants to spend the old amount but there’s a new reality about what is sustainable. We see the results when government spending is cut.

In truth, the economic slow down is based on business and consumers becoming more realistic and they cut the use of their going into debt to inflate the economy anymore. This reduces tax revenues for the government. However, government wants to keep their leveraged spending levels instead, and are convinced that their continued spending is helpful. It may be unless what they borrow begins to exceed what they could repay. And this tipping point is what the markets vote on every day. When the risk of getting repaid goes up (chance of repayment goes down, so risk to lender goes up) (I mentioned this above) , so does the cost of borrowing through the interest rate demanded. The quality of the loan also goes down until the point of default.

Money in the economy needs to come from somewhere. Either from economic activity based on consumers wanting what business produces. Or, through borrowing. Borrow too much today, and you can not spend a lot tomorrow, because you also have a third party expecting repayment for helping you spend more yesterday.

 

This is not meant to be a political blog. I am merely stating this problem through an economics based explanation based on the two book resources linked to above.

 

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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