The Difference between Debt and Deficit and Why it Matters

I was sitting at a bridge table recently while we waited to play the next deals and one of my tablemates made the comment that he was interested to see what happened when the vote to raise the US debt limit came up in the new Congress.

I opined that after much posturing it would, of course, pass, to which he replied, “Well I think in the long run, we should just default. Oh sure, it would cause some problems short-term, but in three or four years we’re better off because we’re bankrupt anyway.” (Or words to that effect—I was so surprised I didn’t think to write them down.)

I objected to the characterization that the US was bankrupt, to which he responded that we were because the debt was greater than the GDP (Gross National Product).

Whoa, Nellie! We’ve got some big misperceptions here, and this isn’t the first time I’ve heard similar incorrect analysis—including from candidates during the most recent election.

First, if Congress chooses not to raise the debt limit, it does not automatically mean we declare bankruptcy. It means the US can no longer borrow money. Since the US government is currently spending considerably more than it takes in as revenue (the current deficit), it would immediately force the government to curtail its activities. Assuming we continued to pay interest on the debt, (and therefore not be in default), we would have to amputate large sectors of the Federal government in order to cut expenses so they meet revenue.

We could go with an all-volunteer army—and I mean all-volunteer, since we wouldn’t pay them any longer. We could cease mail delivery. Shut down all VA hospitals. The list continues, but there is some level of government we could pay for given current levels of revenue.

Or we could hike taxes to bring in sufficient revenue to match current expenses.

Or we could sell off all the national treasures. No one knows what our national art collection would go for. Even in a down real estate market, surely someone would pay a few billion dollars for the White House—or maybe we could just sell naming rights and make it a renewable revenue resource.

Well, I could riff on this for several pages, but you get the point: refusing to increase the debt ceiling means we can no longer run even a temporary operating deficit while we wait to April 15th and the flow of cash that arrives with the end of personal income tax season. In and of itself, it does not cause a default.

The second issue is confusing deficit with debt. The deficit is the annual difference between expenses and revenue. The debt is the accumulation of all prior deficits. It is what we owe others (although in some cases the other is us, but that’s a different story we won’t get into here.) We do have a sizeable debt and it is indeed bigger than our GDP. But that’s the wrong comparison.

When my then wife and I bought our first house for $55,500 we took out a loan for $40,000+ (our debt) and our income was maybe $25,000 (our GDP equivalent). We were not bankrupt because we had one large asset: a house valued at $55,500. That’s why the banks were willing to lend us money.

So too with the United States. At this writing, our debt is slightly over $14 trillion. Our GDP is about $14.6 trillion. In theory we could take everything we earn in the US in 2011 and turn it over to our creditors and be out of debt, except for two problems. One, our annual deficit is running at something greater than $1.333 trillion, so by the time we paid off the old, we would have dug ourselves a new trillion dollar hole. And two, we’d starve to death during the year since most people don’t have enough assets to live on them for a year. (All US numbers taken from http://www.usdebtclock.org/ )

However, just as I had a house backing up my mortgage, the US has assets—including its taxing power—to back up its debt. We are not yet close to being bankrupt.

Which is not to say that our current politicians (of both parties) haven’t managed to run us closer to the edge of the cliff than I would like.

Politicians should hold their collective noses and increase the debt limit high enough to carry us through the next two years. Then they need to get down to the serious business of reducing the systematic deficit created in large part by Bush II’s tax cuts when Republicans decreased Federal revenues and INCREASED Federal expenses.

We need an honest old-fashioned donnybrook in these United States to thrash out the level of government services we citizens choose to pay for. Everyone in America needs to understand our current situation and that it cannot last. Those leaning left will, of necessity, need to support higher taxes to pay for the safety net they think is appropriate. Warmongers need to start paying for their wars in real time with additional taxes to pay for their wars. (“War taxes” has a nice ring to it don’t you think?) Those leaning right need to tell the American people very clearly whose ox they will gore first, second and third until they have decreased government spending to the level of their preferred taxation.

Fortunately for the majority of people in the middle of the debate, neither side of the Congressional aisle can do it alone, and it will take a bit of time to square away. We need that time for current deficit spending to prime the pump as we climb out of the recession. That’s when we should be running a deficit. When better times roll, we should balance the budget; and when the good times roll, we should pay down our debt.

So says this social liberal, fiscal conservative. In the meantime, let’s at least make sure the folks with votes in Congress know the difference between a deficit and a debt.

~ Jim

How to Get Rich in Less than One Hour a Day

Happy New Year, Readers.

My skepticism was roused by the headline in a full-page ad in Smart Money magazine: Make Up To $500 In The First 59-Minutes of Every Trading Day.

Heck, anyone can make up to $500 in the first hour of trading. (Conversely, you can lose up to all your money if you did everything wrong.) What I found intriguing about this ad was the sophisticated use of psychological triggers to hook the buyer. There is no over-promise: up to $500 doesn’t sound unreasonable, does it? And the use of the first 59-minutes of the day rather than an hour. That specificity tends to lead credibility to the claim.

It gets better as you read the ad. Turns out the promoter – Manny Backus by name – is a smart dude with an IQ of 157. And he plays chess – only brilliant people play chess, right? The ad features a picture of a clean-cut male dressed in a suit and tie about to move the black queen on a chessboard.

Oh, and act quickly because there are a limited number of seats available in his exclusive club – 575 to be exact. When I went to the website listed, the specific number of slots available (23 when I showed up – a nice prime number, implying 552 people have gotten there before you and the pressure is on – don’t let 23 people get this great deal while you dither about pulling the trigger.)

Finally, there’s a thirty-day free trial. What can it hurt, eh?

Now I don’t know Manny Backus from a hole-in-the-wall, but here’s how I figure the system works for him and how it would work for you if you were to follow it after the free month. He chooses one or two stocks each morning that because of perceived order imbalances will be overbid or oversold at the stock market’s opening or soon thereafter and therefore are likely to either slip back or bounce up from the opening price. He sells short (borrows the stock and sells it) the overbid stocks and buys the oversold stocks. He uses limit orders for protection. He has a target price to close out the position (buy back sold stock, sell bought stock). The idea is to avoid being too greedy, just make a little on each trade.) If he has erred in his judgment he has a predetermined price at which to close out the position.

You and up to 574 other members of the exclusive club are in a chat room where Manny gives you the information and tells you when and what he has bought or sold. There is no proof that he is making these trades, but I suspect he is in order to avoid legal entanglements. Let’s say he trades a round lot (100 shares) for $1 trading cost each way. Four trades a day (two stocks round trip buy and sell) that will cost him roughly $1,000 a year—as we’ll see that’s chump change.

Once your trial period is over, membership costs $297. (Not a round $300 – we humans feel we’re getting a bargain anytime a price ends in seven.) If he has a full book of 575 active members that earns him $170,775 per month. That’s over $2 million a year. Even if he can only keep 100 members active at any given time that’s still $350,000 a year.

Manny has a really nice business going based on the memberships alone.

Now let’s assume Manny takes more than a nominal position in the trades he presents. He asks people to have at least $25,000 in their trading account. Let’s just assume Manny trades with that much himself to show he’s doing exactly what he suggests others do. Because he makes his trades and tells everyone else, he gets to front-ride his members. While some of his stock picks are highly liquid, I’d guess others have a thin market, which means Manny’s followers will move the market by their trades. Let’s see how this could work.

Let’s say Manny proposes to short the YTREWQ stock. (My intention is to make up that stock symbol.) He says he hopes to do it at say $25.00. He’s hoping for at least a 1% gain and so his initial target buyback would be about $24.75. The stock doesn’t quite reach $25.00 and Manny ends up shorting at $24.90 and tells his followers that’s what he did. They all hit their trading keys to sell shares and with a bunch of people selling at the same time, those folks buying don’t need to pay as high a price. The stock price quickly drops as his followers make their sales and levels out at (say) $24.55 where Manny buys the stock back.

Manny’s made a bit less than his target 1% on this transaction but can proclaim it as a successful trade since he made a bunch of bucks in a few minutes time. For a 1,000 share trade using his entire $25,000 trading account, he would have made a quick $200 less commissions.

Now what about the followers? Those in their free-trial month who are shadow-trading (i.e. making the trades on paper and not with real funds to see if the system works) will buy and sell at the same time and price as Manny does and credit their paper account with $200. If Manny wins, they will win and more often than not Manny will win. What about those who are trading in real accounts?

Those most nimble may have been able to sell their shares close to $24.75, but in a thinly traded stock the price will decline quickly and many will only be able to sell at (say) $24.60 or lower. Once Manny’s troops are done selling, the artificial sales pressure to keep the stock price down disappears. Manny puts in his repurchase order and announces the action. Now Manny’s followers begin to buy and the share price springs up. Again the most nimble will be able to get out at a price close to Manny’s. Others will be lucky to get out at the same $24.60 for a wash. The slowest will have a loss on the deal.

Manny’s results will be much better than his followers because they are following his trades and by following, helping assure Manny’s trades (and those who are shadow-trading) work. Because his followers reinforce his choices in the market, they act like a little insurance policy that his picks will work out.

Over the long run, I anticipate that many if not most of Manny’s paying followers will be disappointed to find that not only are they not earning 1% a day (which he does not promise, but suggests by having a calculator on his website which he has you use to determine how much money you can make a year if you earn 1% a day), they are losing money—particularly when the $297 monthly fee is included in costs. Newbies who are shadow trading are making money—and enough of them will fill the ranks of the paying who drop out to assure Manny his stable monthly income.

From time-to-time Manny will hit a big winner. When that happens he’ll have a cadre of loyal proponents until he makes a really bad trade and washes a bunch of people out. Psychologists know the strongest behavior modification technique involves random positive reinforcement. That is exactly what Manny’s product will do since there will be periodic winners and losers with an occasional big gain. The ones who early on experience a big gain are the people who will write true accounts of their success under Manny’s tutelage that Manny will use on his website as testimonials.

In short, assuming Manny is doing everything legally, he’s invented a great way to make consistent money off human rabbits.

Rabbits get fleeced. Don’t be one of them.

~ Jim