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Economic Stimulus Package Analogy

February 4, 2009

Here’s an analogy which helps me understand the implications of the economic stimulus package presently before the US Congress.

Consider:

  • A family’s combined income is $48,000/year.
  • Their mortgage payment on a house is $1,000/month.
  • Their total monthly expenditures are $4,000/month ($2,500/month non-discretionary, $1,500/month discretionary).
  • They have $96,000 of equity in the house.
  • He loses his $24,000/year job so their combined income drops to $24,000/year.
  • They immediately pull the equity out of their house, which doubles their house payment to $2,000/month.
  • They continue to live the same life style and draw from the house equity at $24,000/year to make up for the lost income.

The end-result is that within four years they’ve burned through all the equity in their house in addition to finding themselves:

  • Living on half the income – $24,000
  • Having a higher ratio of non-discretionary spending ($3,500/month non-discretionary, $1,500/month discretionary
  • Having doubled their mortgage payments from $1,000/month to $2,000/month
  • Extending the payback time of their increased debt

Instead of immediately borrowing to maintain the current economic status, wouldn’t it be wise to first eliminate discretionary spending and try to figure out ways to reduce non-discretionary expenditures? Wouldn’t this be a prudent thing for our government to do? Yet, I don’t see our federal, state, or municipal governments actively cutting expenditures. Perhaps that will come. Right now, however, our government’s main emphasis appears to be “borrowing” additional money in order to keep things as they are.

 

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2 Comments leave one →
  1. February 5, 2009 3:30 am

    This logic works for a family (micro-economy), but not for a country (macro-economy). If everybody in a country decides to cut down on spending, then we have a recession or a depression in our hands. This is called the Paradox of Thrift.

    The hope is that this stimulus is a temporary exercise that will kick-start the economy.

  2. Bob permalink
    February 5, 2009 8:01 am

    Thanks for the comment, Alan. I know all analogies eventually break down. But one thing seems clear – and that is, whatever money is used for the stimulus package has to come from somewhere. And, unless the currency is devalued, that same money will have to be paid back – with interest. At least, that was my point with taking out the equity in this family’s house.

    More to the point, I see a correlation between this family paying out huge sums of allowance money and their inability to remain solvent. Perhaps little Billy and Sally can learn to live with less. Perhaps our government can learn to live with less.

    As to the cutting down on spending per your point of our country and macro economics, money is in many ways a commodity and the use of that money will rise and fall depending upon the cost of using it. We buy coffee and lots of other stuff when its on sale. Many more people will buy houses when the interest rates are low.

    And one last thought, I don’t disagree that we live in a spending-type economy. The problem, as I see it, is that this country (by and large) is not paying for things with cash. Rather, people use credit. And now the bills are coming due and the interest on the borrowed money is crimping the ability of people to pay back the loans. At least, that’s part of what I was trying to show in my analogy.

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