Time Value of Money: A Math Lesson our Leaders Need to Learn

Over the last couple of centuries our government has borrowed money to fund wars, expand the welfare state, and to generally intrude itself into the daily lives of all Americans.  Over the past decade or so, the government has accelerated this borrowing at a dizzying pace.  As anyone who has turned a teenager loose with a credit card can tell you, this is a recipe for disaster.  Within the next few years simply servicing the interest on the national debt will exceed Medicare, Social Security and Defense to become the single largest outlay in the federal budget.  If we continue at this pace, the cost of servicing the debt will, eventually exceed the productive output of the country.

"How can this be" you may ask?  It all has to do with compound interest and a nasty little exponent in an otherwise innocuous equation; the same equation which makes the final cost of buying a house with a 30 year mortgage, even at a modest interest rate, more than twice the original selling price of the house.  This is the equation:

A = (P+r/n)^nt

A = final amount
P = Principal
r = interest rate
n = is the number of times per year the interest is compounded
t = the life of the loan in years

The exponent in the above equation means that the cost of the loan increases exponentially with time.  That means that as time passes, the curve becomes more vertical.  Over time the curve will approach the vertical, yielding a near infinite growth rate.  For the equation above, at reasonable interest rates, this will take quite a long time to occur.  However, the curve doesn't have to approach the vertical for us to be in trouble.

The productive output of the country, the GDP grows along an exponential curve too.  However, this growth averages from 3 to 5 % and has often been negative over the past several decades.  You can check out historic GDP growth here:
http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=USD

The problem is that the national debt is growing at a much faster rate than the GDP.  In fact, next year, the debt is expected to exceed 100% of GDP for the first time since the aftermath of WWII.  As a percentage of GDP, the debt has grown from about 70% to about 95% in  just two years.  Most of this growth has been due to massive increases in spending, some of it temporary, but much of it in new long-term commitment to entitlements.

Once the debt reaches the level of GDP, if the interest on the debt grows faster than GDP, then even if we manage to balance the federal budget and don't borrow another dollar, the federal debt will continue to grow until the interest alone will dwarf the productive output of the nation.  

We've been to this point before. After WWII, as a result of paying for the war and the reconstruction of Europe, the debt actually exceeded 120% of GDP.  The difference between then and now is that most of the government spending that led to the debt was war related or related to the reconstruction of Europe.  Also, the war was followed by a period of massive economic growth fueled by the fact that the American industrial base was practically the only one that survived the war.

The situation is much different now.  Most of our government spending represents ongoing commitments to entitlement programs; programs which are, themselves growing in cost at an exponential rate.  There is little hope that the current leadership in Washington will cut any of these programs.  On the contrary, they seem to be growing them while giving little more than lip-service to paying for them with cuts elsewhere or increased taxes.

Case in point is the recent tax bill which not only extended tax cuts to stimulate the economy, but included increased entitlement spending to nearly match the value of the tax cuts.  Politicians on the left said that we couldn't afford the tax cuts while those on the right said we couldn't afford the entitlement spending.  Both were right, but when they got together and worked out a compromise, they ended up with both the things they rightly argued we couldn't afford.  That's kind of like a couple arguing over the fact that they can afford neither a new car nor cable television, and end up solving the problem by getting both-on credit.  No wonder we're in such a mess.

Next time, some practical suggestions for fixing the mess.

Time to have another go at the blog

It's been quite some time since my last post on this blog.  Since my last entry much has happened in my own life, and in the world.  Of course, nationally, the scene has been dominated by the historic elections of 2008 and 2010.  We've seen the economy tank and a major philosophical change in Washington.

Personally, I've changed jobs and geography twice, somehow ending up right back where I started.  These changes created chaos sufficient to derail my blogging efforts, as well as distracting me from all sorts of other extra-curriculars in which I was engaged.

Anyway, I'm going to have another go at this blogging thing.  There's much to comment on in this new world in which we find ourselves, and, of course, I have my two cents to give.  I also have some new recipes and cooking ideas that I want to share.  Hopefully things have settled down enough to allow me demonstrate at least a smidgen of consistency in creating and updating my blog.

Wish me luck!