Sustainable Wealth

Achieve Financial Security in a Volatile World of Debt and Consumption

Axel Merk

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470496589
• eBook ISBN: 9780470564370
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

A personal finance guide for today's turbulent world

Sustainable Wealth empowers you to achieve your financial goals by unleashing the shackles of debt, no matter how uncertain the future may be. Filled with in-depth insights and practical advice, this reliable resource illustrates how you can predict economic booms and busts before they happen, adapt to changing markets and plan for lasting financial stability.

Over the course of his career, Axel Merk has been at the forefront of identifying major trends, a leader in the public policy debate on how to fix the economy, and guide for investors looking to navigate the global credit crisis. With this new book, Merk puts your financial decisions in a global context and shows how factors ranging from the Federal Reserve and Congress to trends in Asia and Europe influence your financial well-being.

• Coaches you how to recognize major economic trends before they happen
• Puts forth a plan to help you cope with expenses and save for retirement, while building a legacy of wealth, not a mountain of debt
• Reveals why "staying the course" when governments or markets change the rules may be hazardous to your wealth

As investors struggle to adapt to the new financial landscape, Sustainable Wealth provides straightforward answers to the tough financial questions we face-and the tools to achieve a financially sustainable lifestyle.

PART I

A WORLD OF TEMPTATIONS

In ancient Biblical lore, the world of temptation started with the bite of the apple—and as the familiar story goes, nothing has been the same since. As you’ll see in the next four chapters, we as economic individuals and a society have sunk into a dangerous world of economic and policy temptations. Federal budget deficits in the trillions are but one result.

Arguably, these temptations—the temptations of credit, consumption, policy change and complacency—have not only created and perpetuated bad financial habits, but have led to still greater temptations. The temptation of credit has led to a temptation of consumption, which has in turn led us into financial difficulties as individuals and as a nation. To deal with those issues, we’ve succumbed to the temptation of policy and policy change. Policy change fosters yet another dangerous temptation of complacency—complacency toward risk and the seriousness of our economic problems—and shakes the very foundation of the free market system responsible for our prosperity from the beginning. The cycle may become more vicious, and unintended consequences along the way may create still more economic turmoil.

We’ve bitten into several bad apples, all of which create volatility, all of which will make it more difficult to create and sustain wealth in the future. Understanding and dealing with these temptations to create a secure financial future is the central challenge of sustainable wealth.

Part I, A World of Temptations, puts the four temptations and their consequences on your radar. After reading Part I of this book, you will have a much better understanding of the dynamics driving the economy and, ultimately, your finances.

CHAPTER 1

The Temptation of Credit

A pig bought on credit is forever grunting.

—Spanish proverb

Over the past 20 years, the United States has increasingly become a credit-driven society with a credit-driven economy. As recently as 1990, while some consumers ran up their credit cards and many had a mortgage to finance their home, leasing a car or obtaining a loan to buy a car was only starting to become popular. Nowadays, we buy everything on credit, including a mattress or exercise machine; to buy a car, we are lured with zero percent, six-year loans.

Is that a good thing or a bad thing? In the 4th century B.C., Aristotle wrote in his book Politics, “the most hated sort [to make money], and with the greatest reason, is usury, which makes a gain out of money itself, and not from the natural use of it. For money was intended to be used in exchange, but not to increase at interest.” Christianity, Judaism, and Islam have all tried in vain to prevent the spread of credit. Christians were banned from charging interest through much of history; in the 12th century, Christians were banned from receiving sacraments or a Christian burial if they charged interest. Jews were also banned from charging interest, but the restriction only extended to fellow Jews; as they were also banned from owning land, Jews became merchants and the first bankers, giving loans to Christians. Muslims, to date, are not allowed to charge interest; as a result, Islamic loans are typically structured as profit-sharing agreements. The traditional dislike for credit also extended to ancient China, where usury was prohibited. It wasn’t until the Industrial Revolution that interest-bearing loans to facilitate trade became common and accepted practice.

As a result of credit, the economy as a whole gets money to spend now in addition to money it already has. The same goes for your own personal “economy”—credit represents more money to spend in addition to the money you already have. At both levels, it represents an expansion of purchasing power. That has good consequences, but too much of a good thing can mean big problems. Too much money in circulation reduces the value of each unit of that money—that’s inflation. And when more money is created by credit than can be paid back with current incomes, that leads to (or should lead to) reduction in spending and an economic contraction.

During the credit crisis, or credit “bubble,” we saw some of both problems. The access to easy and cheap credit, which has become the standard dose of medicine for economic slowdowns, created—more accurately, amplified—a rise in asset prices. During the early part of 2008, we saw levels of inflation in commodities and asset prices that had not been seen for 30 years. As prices rose, lenders began to see less risk in their lending, and so lent more easily to more borrowers who might not have otherwise qualified. As with most bubbles, everything reversed almost at once, leaving those borrowers who had too much debt and not enough income unable to make their payments. The boom became a bust as more debt went sour, and that cycle fed upon itself. The modern Federal Reserve (or “Fed”) uses consumer price inflation expectations as its sole measure on whether to pop a bubble or not; the Fed stood by idle during the boom, because the asset inflation did not translate into an expectation of higher consumer prices. This focus has its shortfalls, as it allowed an unprecedented bubble to build; in the next chapter, on consumer temptations, I will discuss in more detail what held back consumer inflation.

Other forces in the universe were also out of alignment, including consumer spending, asset prices, and risk appraisal. The fact that the United States had already become the largest debtor nation in the world, and the fact that consumer debt was already at record levels helped to accelerate an increase in insolvency and an accompanying deterioration in confidence, hence the downturn in the economy.

In short, credit is a strong economic force; it has tremendous power to expand or contract an economy—the 2008-2009 experience could hardly serve as a better example. Just as credit amplifies U.S. and global economies, it also amplifies your own personal economy. Used wisely, it’s a good thing. But if you fall to the temptation of credit and spend too much, it can throw your own economic universe out of balance and lead to far greater problems later.

The Relationship Between Credit and Debt

Credit, in its purest sense, represents a potential, an ability, to borrow money to pay for something. A credit card is simply a device for doing that—by buying something on a credit card, you’re exercising a promise to pay that amount later. “Later” can be any time; you can pay off the balance at the end of the subsequent billing cycle, with no interest, or you can let the balance roll into the future, incurring interest charges along the way. The “later” may become “never” in case of bankruptcy or death.

Essentially, when credit is used, it becomes debt; credit is a future opportunity, whereas debt becomes a present reality. Credit can be a good thing, for it enables you to buy more goods at a time in the future. But when too much credit is used, it becomes too much debt. The buildup of onerous amounts of debt can naturally get you into economic trouble.

On a global or national scale, credit is simply the ability to borrow—or print—more money for governments to spend directly (fiscal stimulus) or to put into the banking system so banks can spend it (monetary stimulus). Just as for consumers, credit used and spent or placed into the economy becomes debt.

Good Credit, Bad Debt

Imagine, for a moment, a world without credit.

Now, as a consumer, you might be able to get by. You earn money doing whatever you do, and you take that money and buy food and clothing and other basic necessities of life. You rent shelter, so the amount you have to pay is current to the amount used or consumed. Before the days where everyone everywhere had credit, this is how people lived. In fact, you probably lived this way through college, assuming your tuition bills were taken care of elsewhere through savings or scholarships. You didn’t have income, so—at least in the pre-1990s “old days”—you probably didn’t have credit, because no one figured that you could pay it back once it turned into debt.

As soon as you need something that you can’t pay for right away, credit assumes a center stage role in your economic life. That could be college tuition, if you, your parents, or your grandparents didn’t save for it. Or, through the course of life it could be a car or a home or furniture for a home. Credit enables you to purchase those things when you need them and pay them off over time. You can have them and use them, and if you earn enough to pay for them plus the interest accrued, you’ll come out okay. If they are things you really need, it makes sense to use credit to buy them. However, if they aren’t really needed, then credit is simply enabling you to buy things that you can’t afford. Do that enough, and you’ll create a debt, which has a rather persistent tendency to grow once it gets started—it’s too easy!

Credit can make your own personal economy work better if used to buy things that you need, or things like college tuition that have a greater payoff down the road. But do you really “need” all the things many take out credit for? One can make an argument for college tuition; however, college tuition may be the one bubble yet to burst, as there has been a popular mindset for too long that thinks that the more expensive a college is, the better it must be. At some point, when we cannot afford the tuition anymore, even with the help of loans, college tuition should come down. There’s certainly an argument to be made that you don’t “need” most of the things you consume. You don’t need that TiVo, you don’t need that vacation in a five star resort, you don’t need that new pair of sneakers or that pedicure.

As the U.S. economy digests the “credit crisis” of 2008-2009, many are wondering just what the proper role of credit is. It is an important question to ask, as there are pros and cons to credit. There’s a saying that those who understand interest charge it; those who don’t understand interest pay it. In my humble opinion, a society that embraces credit had better understand it—as that society otherwise will pay dearly. If you buy everything on credit, your monthly paycheck may get you much further: you pay $200 for your car and $13 for your mattress every month, rather than waiting until you can pay for them in full. Former Federal Reserve Chairman Alan Greenspan (who was Fed chair from August 1987 through January 2006, and largely oversaw the transition to using credit in every facet of our lives) praised this trend, as it made the U.S. economy more “efficient”—money sitting idle in your bank account is money that does not contribute to economic activity; conversely, when you make a down payment on a loan, you are leveraging the usefulness of that down payment.

But it’s a two-edged sword—borrow too much, and the burden of paying back the debt, plus the cost of the interest, can get you in trouble. Too much debt makes a consumer—or a business or a society—more vulnerable to shocks and surprises. A job loss, big medical bill, or car repair is a lot harder to accommodate with a debt burden to service in addition to ordinary, current expenses. If you know how to deal with credit, you may thrive; if you don’t, you become a slave of your debt. As a result, easy access to credit without the proper training for those who receive it increases the wealth gap.

The Debt Spiral

So credit, used to fund the right things, can help both a consumer and a business. But used too much, or used for the wrong things, it can lead to trouble. Consumers, businesses, even responsible governments can run out of steam.

Credit excesses create a downward spiral. When consumers or businesses have too much debt, there’s a tendency to borrow more, either as a perpetuation of bad habits, or to “clean up” the debt—to consolidate it and make it more current. Remember the push to get you to sign up for a home equity loan during the boom phase of the credit bubble, to “pay off all those bills?” That’s an excellent example of the so-called debt spiral. Essentially, the message is “borrow your way out of debt.” That sounds like a pretty strange idea, right? I’ll come back in Part II of this book to give more pointers on managing personal debt.

Access to credit has major implications for the social fabric of a nation. As a result, it is high time that a public debate be held addressing how much credit we deem is healthy for society as a whole and for the government. Most would quite likely agree that credit plays an important role, provides opportunity, and has contributed to our standard of living; returning to a society based on barter alone is something most would not favor. Conversely, however, the credit bubble has shown that extreme credit may lead to catastrophe. The level of credit in a society is not simply decided by bankers, but influenced by tax and interest rate policies, among others.

To a great extent, it is a political choice. Every citizen should have a view as to whether we want to move further toward a Latin American society, with a thin class of the very wealthy, but the masses living in poverty, or foster a strong middle class. While most have views about how tax policies influence wealth distribution, few are aware that interest rate policies play at least as significant a role: Higher interest rates tend to make for a more robust middle class, as they encourage saving by discouraging borrowing and paying higher returns on the savings; conversely, extended periods of low interest rates lead to a growing wealth gap, with a select few who thrive, but a great many who can’t cope with the easy credit.

Credit as Money

What is credit then? Credit, simply defined, is the creation of money to be paid back in the future. Let’s look at what we commonly understand as credit. The most basic form of credit is currency in circulation—the dollar bills in your pocket. It’s credit because currency represents a loan issued by the Federal Reserve to you. The money printed by the Fed is credit; a dollar bill is a Federal Reserve Note, the most basic form of “money supply.” The only peculiar thing about this most basic form of credit is that it is not redeemable unless the Fed chooses to retire the bills. If you were to take your dollar bill to a bank or the Fed itself, all you would get in return would be a sheet of paper stating that you may exchange it back for a dollar bill. I’ll talk more about the Fed’s ability to print money further below.

How Banks Create Credit

Most of us think of credit as what happens when a bank issues a loan. Banks take deposits and use them as a base to extend loans. Banks lend out a multiple of what they have as deposits. That bank lending is money creation, too; money is not physically printed, but created nonetheless. And indeed, the person receiving the loan will buy something with it; let’s say the borrower took out a loan to buy a car. The car dealer may then deposit the proceeds from the car sale with his bank. As that is a deposit, the bank can make fresh loans. While an initial deposit may be leveraged about 10 to 1, by the time every loan has made it through the system as new deposits, an initial $1 deposit may increase to serve about $100 in loans. Healthy banks are crucial to a credit-driven society, as they are a key engine for creating credit.

How the Fed Creates Credit

The Fed influences the amount of credit available, not only by printing currency but by other means. The Fed also sets the reserve ratio, the amount banks must keep as collateral when making loans. The Fed is a membership-based organization, and member banks are required to keep a deposit at the Fed.

But Fed money creation goes a step further. Whenever the Fed buys something, it creates the money—it’s merely a bookkeeping entry, done with the stroke of a keyboard. When the Fed buys a typewriter or a car for a staff member, the Fed provides a stimulus to the economy. To stimulate economic growth, the Fed is better known for buying securities, traditionally Treasury securities, from banks. When the Fed buys a Treasury bill from a bank, the Fed receives the T-bill and the bank receives cash; this is all done electronically through bookkeeping entries—no physical cash changes hands. With the cash received, the banks can make fresh loans. This activity is commonly referred to as “adding liquidity” to the banking system. Conversely, if the Fed wants to reduce the credit available in the economy, it can sell securities to banks, typically Treasury securities. By selling securities to banks,...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Foreword
• Preface
• Introduction
• PART I - A WORLD OF TEMPTATIONS
• PART II - ACHIEVING SUSTAINABLE WEALTH
• Resources
• About the Author
• Index