Tuesday, September 30, 2008

The Cash Society

As we stand before the precipice and look down, we need to take inventory to see how we got here. The 30 year mortgage has been around for a long time, and recently, within the last 30 years, it has gone through some permutations. As some may recall, around 2003, the Adjustable Rate Mortgage (ARM) became wildly popular.

The decision to create, market and finance ARMs turned our fortunes. Think about the brokers who sold them. Where are they now? Some could see this current crisis coming, but few were willing to openly answer the obvious questions: what happens when the rates start to adjust? As payments on these loans began to increase, so did late payments, defaults and eventually, foreclosures.

Setting that aside, lets look at the 30 year mortgage on its own. A simple calculation reveals that a mortgage paid at 7% annual interest, assuming 10% down, will more double the cost of the home you buy over 30 years.

The pattern is similar for auto financing. The interest costs are significant for autos and they can increase the cost of the car often by 50% or more over time.

Now lets look at credit cards. Some people are lucky enough to have 0% or a low 5-6% interest rate on the balance. This makes the cost seem negligible relative to the benefits and convenience of credit. If you miss a payment, however, the fine print says that your rates could go up significantly. The rates for credit cards held by teetering payers can shoot as high at 30% or more.

The bottom line is that all forms of credit make everything more expensive. Everyone has heard of inflation. We see it all the time in the news. And there are so many ways to measure it, too. Inflation is defined as an increase in the cost of goods over time. While the cost of a broom may rise over time at a constant rate, the cost of food and fuel can fluctuate wildly.

Credit is a hidden form of inflation in the sense that we aren't really trained to see how much it costs. This concept gets some lip service when we go to school. But instead of being taught how to avoid it, we're taught that the cost of credit is the cost of doing business. It's assumed to be unavoidable. This leaves an indelible impression upon a young mind.

For many Americans, credit cards have been used to maintain a standard of living. It is not unusual for people to accumulate $10-20,000 in personal debt through credit cards. This debt is often accumulated through the use of credit cards to pay for living expenses when the economy is slow. Many will use credit cards to purchase vacations and luxury items they couldn't otherwise afford. But few if any can imagine a life without using credit.

 I know at least one man (whom I admire deeply for his business savvy) who doesn't need credit in the sense that most people are familiar with. He built his business on cash. He pays his invoices early for the discounts he receives from the vendors who offer early payment discounts. He owns all of his equipment, and the building from which he runs his business. And since he has no debts, he doesn't panic when the trade gets slow. He just lays people off and reduces purchasing until the level of employment and the need for materials matches the rate of business that he's doing. When business picks up again, he hires and buys.

Without loan payments to make, which are constant over time, he can adjust his cash flow with the business instead of with the bank.

Credit doesn't just make everything expensive due to the interest paid on the loan. Credit is used in this country to create artificial demand. This demand increases prices. That's why the crowd goes wild every time the Fed drops their rates. And I dare say that credit also creates a pool of cheap, skilled and willing labor, tied to the ball and chain of debt. Whichever came first is still in debate.

Let's look at the hidden costs of credit at the checkstand in simple terms: if you don't have the money, you can't buy it. But if you have credit, you can just pay it off over time. This increases demand for goods and services. And demand creates inflation.

As to the labor pool, here's the big picture: You are employed. You have a home loan, an auto loan, and maybe a few college loans, a few credit cards and a family to support. But you have no savings. A vacation is a far off fantasy without a credit card or a line of credit on your house. Worse, you can't choose the job you want or the pay that you want because you have to keep working to keep making payments.

Imagine a parallel universe where you have a year of expenses saved up. Now you can kiss your boss goodbye (ew!) on good terms, and take your time finding the job you want. Or you can take a month off to reassess your direction in life. Whatever. You have a contingency fund to handle most small emergencies, too. With a year of expenses in the bank, the bank wants you to stick around. Like I said - it's a parallel universe.

Now there's a study in contrasts. Why didn't we do this from the beginning? Maybe most Americans are masochists who need someone like a banker to help them.

Remember how much fun we were having as we watched home prices double in Southern California (and spike unreasonably fast elsewhere)? That was due to increased demand for homes created by "creative financing" mortgages. By creating easy money loans, people suddenly had the money to get into the housing market. That is the kind of demand for homes we saw then that could never have happened without ARMs.

Without ARMs, people who wanted to sell their homes would have had to either lower their prices or wait. And that is exactly what is happening now. The ARMs are gone. Prices are falling and people are waiting rather than selling.

Without easy credit, prices will have to fall. There is no way for the economy to quickly correct itself. But from a practical standpoint, we are not completely powerless over inflation. If we live within our means and buy what we need or want with cash, we can keep inflation in check. Confused? Let me explain.

If people refused to borrow money and instead chose to save their money, what would happen to the economy? Producers and sellers would have two choices: lower their prices, or wait.

Now consider this: saving money and only using cash is not just a choice, this way of life creates choices. When you use credit, you are dependent on someone else to make the decision for you. In a credit - I mean, debt economy - the bankers make the choice for you. They decide if you will buy something or not.

But if you have the money in the bank, it's yours to spend. And the banker is going to pay you interest if he wants you to keep your money there. It's not so much that you're in control. You simply have more choices available to you. And by tempering your demand with the amount of money you have on hand instead of borrowing, you help to keep prices down.

A cash society lives on the cash they earn, and has more control over prices by controlling demand and can make spending decisions that are relatively unencumbered by the interests of bankers. Remember, a banker is only your friend to the extent that you are willing to pay him back on the loan, or to the extent he is willing to pay you interest on your deposits.

The choice is yours. Where do your interests lie? Pay or be paid?
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