Indispensable Economics The parable of the new car

Aug 11, 2011

Once upon a time, there was a man, let us say for the sake of the story it is me (it isn’t but if I did these things, I would be in the same state as the man in the story). One day my 11-year-old Buick died.  So, I needed another car. But, instead of getting a nice used car for cheap, like the Buick I had which lasted six years, I went out and treated myself to a Ferrari. The price of this new car was over $225,000.  Now I am a man of modest salary, and I already have a mortgage on my house and am trying to pay off credit cards, which means that I do not have that much discretionary cash.  But the payment on this car (I looked this up in the amortization tables) at five percent for five years, (the most they usually allow in a new car) is $4,700 per month. Since, up to this time I had a good credit record, they actually loaned me the money.

So I came home with the new Ferrari, and, after my wife stopped hitting me on the head with her rolling pin, she yelled at me for spending too much money and for putting us in so much debt.  I felt very badly that she was so upset, so I decided, as soon as the headache went away, that I would do something nice for her.  Since my wife does not have her own car (again, for the sake of the story), I went out and bought her a car.  But since she was mad that I spent so much on the Ferrari, I decided to get her a cheaper car, so as not to spend as much.  The car I bought, a Mercedes-Benz, cost $42,000 and the payments, at five percent for five years would be about $800 per month, surely a bargain compared to a Ferrari.  This means that I just boosted by monthly liability payments by $4,700 + $800 which equals $5,500 per month.

For a man of modest salary and only a small amount of discretionary cash, this payment is way too much.  Suppose, for the sake of the story, I am not allowed to give the cars back.  Even if I did, they would be considered used cars and I would still owe a chunk on them, though nothing like I am currently paying if I keep them.  How do I make the payments?  I borrow the money.  After all, I made these purchases in only two days, maybe they have not gotten into the credit system yet.  Suppose I got some credit cards with high credit levels?  I would not have to borrow the whole payment from the cards every month, because I could make some part of the payment with my discretionary cash.  I would, however, have to borrow a large portion to make the full payment.  Maybe I could make my wife go to work, if she is not already working (in real life, she is).  Maybe, I can suddenly get hired as a vice-president of a big company so that my salary will take a big jump.  But is that likely to happen anytime soon?  No.  Basically, I am in serious financial trouble.

Now, what is the meaning of this parable?  If the reader did not already see it coming, we can compare the man in the parable to the Federal government.  The man got attached to material goods, and not just any goods, but fancy, expensive cars, probably due to the mid-life crisis syndrome.  The populace gets attached to transfer payments made to them, called entitlements, and the government gets attached to the power that comes to it in return for promising these entitlements to the people attached to them.

But the government and the populace, who pay for these things, cannot really afford it, and, like the wife in the example, will shout and scream about the cost. So the government (husband) goes and gets loans to pay for the entitlements, and to appease those who complain about the spending, gets them some goodies, like bail outs for profligate banks and companies, the executives of which get to keep their jobs.  Of course, to do that, the government has to borrow more, and in a pinch, the Federal Reserve Bank can counterfeit some cash, which the man in the parable would go to jail for a long time if he got caught doing that. 

Meanwhile, the people (like the wife) are furious and are worried that the whole edifice will collapse. Just like the family will have to declare bankruptcy, the government will have to default on its debt.  So the government (husband) finds a way to keep borrowing, though a lower amount, to enable everyone to keep their programs (and their cars), the protesters (wife) having gotten used to the bailouts (the Mercedes-Benz), etc. 

This is the recent debt deal worked between Democrats and Republicans.

Spending was not cut; just the rate of new spending is less than the old rate. We can still borrow more money, which we will also have to pay back, but since the economy has been malfunctioning for some time (no gigantic pay increases for the husband) where will the money come from? 

This parable is not far-fetched in any sense of the word.  The laws of economics, which are not laid down by anybody but come from the actions of humans, are the same for all.  Milton Friedman famously said that there is not such thing as a free lunch.  For those too young to know the reference of this wise statement, my grandfather, who was born in New York in 1880, told me that bars in those days advertised a free lunch.  Of course, most people going in to get a free lunch, got some alcoholic beverage.  The cost of the beverage was high enough to pay for the food, so the lunch was not free.

Everything has to be paid for, and the debts incurred are not incurred by the “government” but by the individuals in government whose actions try to defy the laws of human action—the laws of economics.  Just as the husband in the story would be a fool to buy a Ferrari with the income he has, and then buy a less costing but costing nevertheless Mercedes-Benz right after that, so the people in government are crazy to think that they can keep promising and giving benefits to voters without considering how to pay for them.  Thus endeth the lesson!