Reward Cards: Cash Versus Points

By: Jason Steele

08/13/2009

I was reading the One Mile At A Time blog, and after having won their photo contest, came across this post entitled “Is it time to rethink the cash back credit card?”. The title perplexed me, as I love cash back cards. As I read the post, I got to contemplating the nature of cash back versus reward points.

The rational conclusion that the author reaches is that points are rarely worth more than 2%, the current cash back standard set by Schwab bank’s card.

Cash is better than getting something of lesser value for free, right?

This would seem to make sense, but it doesn’t. Try this experiment, or make it a thought experiment if you are married. Go to a bar, and give a stranger of the opposite sex five dollars. I doubt that their reaction will be as favorable as if you had purchased him or her a four dollar beer. That is because gifts have an intrinsic value that money does not. When we redeem points or miles for free flight, we feel that we are getting a gift for our loyalty. That we might value that gift greater than it’s actual value, or it’s opportunity cost is more rational than it sounds.

Let me give you another example. Imagine you want to a birthday present for a friend, but you cannot decide what he wants for his birthday. You are tempted to give your friend cash and let him decide for himself, however, you realize that he likely to save the money or spend it on necessities. The point of the gift is to make him happy, and ultimately you realize that can only be done by purchasing something that he would not have otherwise bought for himself.

Points and miles present the same dilemma when compared to cash back rewards. A mere 2% cash back may be worth more than the points or miles, however it will ultimately be factored into your monthly payment, and you will see no direct, tangible reward. I could give you a 10% cash back reward, and it will be about half satisfying as a coupon to Bed Bath and Beyond. On the other hand, earning miles towards a plane ticket to Hawaii is totally satisfying, even if the value of the plane ticket is less than the cash back you would have received.

At Least One Rational Reason Miles Beat Cash

One of the nice things about reward cards is that they often come with a hefty sign up bonus. Needless, to say, cash back cards typically do not come with some free cash for signing up. Some do, but it is often a mere $50. On the other hand, my American Airlines CitiBank cards each offered 30,000 miles for a sign up bonus. When you add in the sign up bonus to the miles earned from spending, miles and points cards can start to get competitive.

Another reason is that there actually are some rewards that are worth more than 2%. My Starwood Amex gives me Starpoints that can easily be worth more than 2% when redeemed for hotel stays and even with just the right airline redemption.

Generally, The Advantage Goes To Cash

That said, cash has some major advantages. Inflation aside, cash holds it’s value much better than miles or points. These loyalty programs are always being devalued and can potentially be discontinued. Even better, cash can earn interest, whereas I have yet to find a bank that takes StarPoints for a deposit. Cash is supremely flexible, even more-so than a StarPoint. I can redeem cash at any merchant, anywhere in the world, and can even pay my bills with it.

In the end, it is up to each person to weigh the rational and irrational arguments for themselves in the cash versus points debate.

Walletpop.com Interview

By: Mr Credit Card

08/11/2009

A few weeks ago, the folks from walletpop.com interviewed me on their blog talk radio show. You can listen to the interview here.

Well, yesterday I got to interview Andrea Chalupa, who is an editor for Walletpop. The interview was only half an hour (departing from my usual one hour show), but I asked her questions about walletpop and some of the articles she has written.

You can listen to the show here.

New Fees?

By: Jason Steele

08/10/2009

The issue of credit card fees never seems to go away. Recently, the passage of the Credit Card Bill of Rights has brought them again to the forefront. It is popular to write articles claiming that this new law has been causing banks to increase fees. I would like to take a more critical look at this analysis.

Are There Really More New Fees?

The USA Today seems to think so. Today they printed this article; “Credit card issuers pile on new fees”. In it, the author Kathy Chu cites several example of some new fees. Exhibit one: “In June, Fifth Third Bank began charging a $19 fee if credit card borrowers have no account activity in 12 months.” Ok, first, I spend hours a day reading and writing about credit cards, and yet, I have never heard of “Fifth Third Bank”. According to Wikipedia, they have been around for 150 years and have branches in 12 states. Still, they are not exactly as big a card issuer as Capitol One or US Bank. Second, $19 for no account activity for a year hardly seems like a big deal. It wouldn’t surprise me if anyone every pays this. 99% of the people who receive a statement with this fee probably just forgot they even had the credit card, and canceled it the next day. The other 1% are likely deceased.

Exhibit 2 is that Citigroup “has rolled out a policy where certain credit card borrowers who pay late are subject to a “reinstatement fee” to be able to redeem accumulated points for rewards. This fee is currently $0. But it won’t stay that way, predicts Robert Hammer, who consults with the industry, if Citigroup finds cardholders aren’t objecting to the policy. Citigroup spokesman Samuel Wang says, “We currently have no plans to raise it.” Call me crazy, but a $0 fee isn’t a fee, even if an industry analyst predicts, despite Citi’s denial, that it will one day be greater than zero.

The USA Today article also mentions that “Discover now levies a 2% fee on purchases made outside the U.S., and Chase has introduced a $30 annual fee on its popular Freedom credit card for certain cardholders.” This is not shocking either. I don’t how long Discover had a foreign transaction fee, and frankly, I am surprised that Discover is even accepted overseas. As much as I hate these fees, they are common to most, but not all, credit cards. The annual fee for the Chase “Freedom” card is pretty anecdotal evidence as well, especially as it only pertains to “certain customers”. I imagine those customers are the ones who actually pay it rather than switch to one of the many competing, fee free cards.

The author then proceeds to recite the industry sponsored boiler plate about how new fees are a necessary reaction to the new legislation.

So What?

Let’s face it, the USA Today is not exactly the home of the most pavement pounding muckrakers in the journalism world, so such an article will not shock the millions of business travelers who found this paper underneath the door to their room at the Courtyard Marriott.

That cannot be said of the prestigious New Republic magazine. Today, their online blog, The Plank featured a post on “Credit Conditions In The Absence Of Consumer Protection.” In it, they ask if “retail credit conditions, i.e., the terms on which you can borrow, getting easier or tougher? On credit cards, there’s no question: it’s getting more expensive to borrow, particularly because new fees and charge are appearing.” To support this conclusion, they offer a link to none other than the aforementioned USA Today article.

I like the New Republic, and I read their blogs daily, but citing this shoddy USA Today article is really beneath them. As far as I can see, there has not been any across the board increase in credit card fees. Yes, some have gone up, but some have gone down. For example, the Consumerist writes that Amex and Discover have dropped their “over the limit” fees, rather than make them ‘opt-in’ as the law will require. I could easily write an article showing just as many other fees that have been eliminated or have gone down. More importantly, I can probably show many new card offerings with no annual fees and cards with annual fees that are no longer being offered due to their unpopularity in a highly competitive marketplace.

So did the New Republic Get It Wrong?

Ironically, I do agree with the conclusions of the New Republic article. I think there should be greater regulatory oversight of the credit card industry. I am glad that a rare combination of circumstances allowed the Credit Card Bill of Rights to pass. This kind of regulatory action should occur whenever banks abuse customers. We should not have to wait for another president to take office at a time when banks are getting billion dollar bailouts and the president has super-majorities in both the House and the Senate. The stars were aligned in the interests of consumers this year, but there is little or no evidence that this legislation is having an negative effect on credit card fees and penalties.

I will admit that APRs are a different story, one that I hope to address in a future post.

Credit Cards and College: What Parents Need to Know

By: Mr Credit Card

08/08/2009

Having your children go off to college can be a stressful time for any parent, particularly with the knowledge that the average college student carries over $2,200 in high-interest credit card debt. So how can you teach your children responsible credit card use? Here’s some good advice to send your children off to school with the information that will prepare them.

The best way to teach your children responsible credit card use is to talk to them before they move away on their own. Before they go off to college, sit down with them and go over credit card offers together. Explain to them the terms and conditions, exactly how cash back credit cards work and even complete the credit card application together.

Start by looking online together, going to different banks to find the best kind of credit card. Student credit cards may be especially good. Explore rewards programs, cash back credit cards and limits and, when you have found a good potential credit card, get an application.

Next, read the fine print and help them understand what it means. Talk to your child about the consequences of late payments and going over the limit, as well as how much they’ll pay in interest each month and what happens if they don’t pay their balance in full. This is also a good time to speak to them about the importance of building a good credit score and how the choices they make now will affect them for years. After you’re sure your child understands the consequences of credit, fill out the credit card application with them before they go away to college.

Another important credit talk you should have before they go off to college involves credit card fraud and safety. Teach your child the dangers of using a credit card by going over safe places to use the card–especially online.

After the credit card arrives in the mail, help your son or daughter develop an efficient way to keep track of their paperwork. Teach them about storing receipts and keeping track of what they’re charging each month. Also show them how to go over their statement and check it against their records for accuracy.

After your child understands how to use their credit card, the consequences and responsible record-keeping, you’ll also need to help them learn accountability with their balance. Help them make sure they pay their balance every month and only use the credit card for reasonable expenses. At least at first, help them by checking in on their situation and discussing what’s going on and how they’re doing with credit use.

And lastly, here’s a note about helping your child through college by paying for tuition with a credit card. In general, paying for college with credit–whether it’s the student or the parent–is a bad idea. With responsible use, however, the right cash back credit card can be a great option for a parent helping their child go to school. According to a study from Sallie Mae, 19% of parents put part of their college costs onto a credit card, with an average amount of $5,822. Most of the people responding to the study said that they used credit cards to pay for college not for rewards but because of money troubles. This may scare many people away from what can be a great way to save some money while helping your child with college. If you have the money and the ability to pay your credit card bill each month, think about using a good rewards card to earn rebates on your college tuition.

When your student goes away to college they’ll be sent dozens of credit card offers weekly. Don’t take the chance that they’ll be sent off on their own with little understanding of how credit works. Sit down with them and discuss responsible credit use and help them develop a system that will make them self-sufficient and financially secure.

Why Your Credit Score Is More Important Than You Think

By: Jason Steele

08/07/2009

Yes, we all know it is good to have good credit. It is nice to always qualify for the latest reward card, to finance purchases, or to a house. That is the easy part. What few people realize is that your credit score is now being used for all sorts of other reasons.

Credit Checks For Job Applicants

The New York Times has an article this week about how companies are using and misusing your credit report in the process of hiring. No longer is being qualified to do the work, or having a good resume enough to land a job. These days, more and more companies are performing credit checks on new job applicants. Certainly, this is a misuse of the credit reporting process. Unfortunately, it is completely legal in most states.

The theory, of course, is that if you make poor decisions in your private life, that you might make those decision for a company. Another concern is that someone in debt will be at a greater risk to steal from their employer. While those may be valid concerns, on some level, it is easy to see how most jobs don’t require financial skills. I also have a difficult time believing there is that much correlation between debt and theft. The article also discusses how the credit reports can merely be an excuse to illegally discriminate on race or other factors.

Combine this practice with the practice of denying credit based on where people shop, and you have a classic case of racial discrimination by proxy.

Of course the most stunning examples of this practice hurting people unjustly are those who have had financial difficulty due to illness. While I pride myself in managing my finances responsibly, I would max out my credit cards in a second if someone I loved needed medical care that was not covered by insurance. Should that disqualify me from a job?

Other (Mis)uses of Credit Reports

It has been widely reported that insurance companies are using credit reports in order to set rates. I know this is happening in auto insurance and it is becoming more common with home insurance as well. It is hard to say what is next. In the future, will you pay more for telephone, cable, or electricity if you have bad credit? Who knows. Is This Fair? Clearly it is not, but it is still legal and it is still reality.

What Should You Do?

While there are a lot of good reasons to maintain good credit, many people can get by without credit cards or debt and feel that they do not need to worry about their credit rating. They are wrong. You never know when you will be looking for a job that will require a credit check. Sure I can construct some scenario where you rent a house, work for yourself, and don’t own a car. Even if that applies to you, damaging your credit will make it very difficult for you should one of those things change.

I have occasionally heard people who have speculated with various levels of seriousness that they should declare bankruptcy so they don’t have to pay for their debts. I have a difficult time finding where to begin in telling them how bad of an idea that is. Knowing that bad credit will haunt their jobs prospects is often a good place to start.

What Is A Charge Card?

By: Jason Steele

08/06/2009

A couple of days ago, I posted this story about a guy who beat debt. One of his solutions was “getting a charge card which feels like a debit card (and pays for itself with the amount I spend), so I never trap myself in to thinking I’ll pay things off later.” Emphasis mine.

What Is A Charge Card

Frankly, between debit cards and credit cards and ATM cards, it is easy to forget that there is another type of plastic option, the charge card.

This is a card designed for deadbeats, people who plan on paying their entire balance in full, every month. Payment in full is required at the end of the month, or a penalty is applied. Multiple penalties could result in the cancellation of your account.

Typically, the penalty is a flat percentage of your balance, one that is less favorable than had you paid interest on your credit card.

In the United States, American Express still offers their classic charge cards, including the iconic original green card. Others offering charge cards include Diner’s Club as well as some individual merchants.

What Is The Point Of A Charge Card?

My opinion here is mixed. First, I am a proud member of the “deadbeat” club. I treat all of my cards like charge cards in that I pay every balance on time and in full every month. That said, you would think that I would love the idea, considering it was designed for people like me. On the other hand, I don’t see the point. I love my Starwood American Express Card, which is a credit card, and I don’t see the need to have a Charge Card.

Some, like the person I wrote about, view the Charge Card as a hybrid between debit cards and credit cards. Like a debit card, they do not pay interest, but like a credit card, they do have good insurance, chargeback protections, and rewards. The only think that really separates it from a credit cards is that the penalties for not paying your bill in full are more severe.

The difference between charge cards and credit cards reminds me of how automobile safety evolved. At some point in the 50’s auto manufacturers realized that people in car accidents were injured by protruding objects on their steering wheel and dash board. They then tried constructing them of soft plastics and foam rubber. Some people wondered if they should have gone the other way, and built sharp, pointy objects in the steering wheel and dash board. The idea is that, knowing the danger, people will drive extra safe.

For many people, a charge card would merely be a large pointy object on their steering wheel. They know that the consequences of not paying off their balance will be especially harsh, so they have more incentive to avoid it.

No Preset Spending Limits

Another supposed feature of the charge card is the idea that there is no preset spending limit. I really don’t put much faith into that claim. The spending limit might not be “preset” but it is still there. The difference is that either they do not tell you what it is, or that it is constantly changing. I suppose another difference is that you cannot be charged an “over the limit” fee. In that sense, it is a good thing in that the worst they can do is deny your charge.

Ultimately, charge cards are a relic from a bygone era. I like the idea behind the assumption that you should never carry a balance. These are words that I live by. On the other hand, there is no real compelling reason to choose a charge card over a credit card. In fact, charge cards are more likely to require an annual fee, where as credit card holders usually do not pay them. I am sure that the credit card issuers are free to waive the annual fee as they know that a certain percentage of card holders will ultimately become “revolvers”; people who carry a balance and pay interest.

True Story Of A Guy Who Beat Debt

By: Jason Steele

08/04/2009

Last night, I saw the show “Man Vs. Food”. It is a pretty funny show in which the host visits restaurants that have some kind of food eating challenge.

In the same vein, last week, I challenged readers to share stories of way they have gone from being “revolvers” to “deadbeats”. (Revolvers are people who carry a balance on their credit card, while deadbeats are those who always pay their balance in full.)

The best reply I got was a reader named Jonathan:

I finally converted from carrying thousands in debt to a deadbeat, but it was one of the hardest things I’ve ever done. I’ve kept the credit cards, but they are all payed off in full. One thing that helped was getting a charge card which feels like a debit card (and pays for itself with the amount I spend), so I never trap myself in to thinking I’ll pay things off later.

To be honest, I have a hard time seeing where I would ever want to finance something on a credit card again. In many ways I’ve bought in to the whole Dave Ramsey idea, but I keep the cards and practice self discipline. You have to understand your own psychology to be able to keep the cards, but it’s possible for some people who are debt prone. The only reason I keep them at this point is business travel and for my credit score.

The secret is living below your means and saving money month after month. It’s a sad reality if you’ve been living any other way, but to solve your money issues, it’s what you have to come to terms with. After you do, it’s extremely liberating and I could never go back to the stress of being broke and living on credit. Every temptation to get back in to debt is countered by memories of the consequences and the new peace that I’ve found.

Jonathan’s case is instructive on many levels.

He Didn’t Cut Up His Cards

For some people, they will literally have to cut up their credit cards to avoid spending themselves into debt. In this case, he was able to control his spending and reduce his debt, while still having cards on hand for business expenses. While I am not familiar with the works of Dave Ramsey, it seems that he is one who advocates cutting up credit cards. I would only recommend that strategy to those who have no self control whatsoever.

He Now Realizes How Bad Credit Card Debt Is

He is feeling better and can’t imagine going back to the old days of paying interest and living month to month.

He Realized The Key To Staying Out Of Debt

Living within your means and saving money every month are to financial responsibility what diet and exercise is to health. There are a million ways to try to get around it, but never underestimate the fundamentals.

He Has Learned His Lesson

It is difficult for me to imagine Jonathan going back into debt again. The last line of his letter says it all: “Every temptation to get back in to debt is countered by memories of the consequences and the new peace that I’ve found.

Equifax Score Watch Review

By: Mr Credit Card

The Equifax ScoreWatch™ is a credit monitoring service provided by equifax, one of the three major credit bureaus. Each bureau, the other two being TransUnion and Experian, have their own monitoring service. And they all come with different bells and whistles. Let’s look at this one provided by Equifax.

Basic Credit Monitoring of Your Experian Credit Report and Score – With this service Equifax will monitor your Equifax Credit Report and Equifax FICO&#174 score. You will get notification of any major changes in your Equifax report or score via email or wireless alerts. In addition, you will get the following service.

Detailed explanations for key score changes and specific tips for understanding your score – so that you can take steps to improve your score

Explanation of your credit score, comparison to national average with graphs of how lenders view you.

Two Free Score Power® reports, plus discounts on additional Score Power® reports – This is a very important point which many consumers do not understand. Basic credit monitoring service is all it is – monitoring. You cannot actually see your credit report or your score continuosly. So for the score watch, Equifax will provide 2 free Score Power&#174 reports. Score Power&#174 Reports is just a term that Equifax uses for their credit report and FICO&#174 score. So aside from credit monitoring, you can actually see your Equifax report and score twice a year. Once you access your “report and score”, you have access to it online for 30 days. So essentially, you are getting 60 days to look at your Equifax report and score.

Monthly Fees – The cost for this service is $9.95 a month.

How Does this compare with other credit monitoring service? – Well, there essentially two types of credit monitoring services. The first type simply monitors just one report (from that particular credit bureaus. The second type monitors all three credit bureaus.

Comparison with TransUnion credit monitoring service – Experian does not have a single bureau credit monitoring service, but TransUnion does. The difference between TransUnion’s monitoring service and Equifax is that TranUnion gives you unlimited access to your credit report. You also have $25,000 insurance for ID theft. But you cannot see your TransUnion score and you do not get alerts when you score changes. The cost is also higher at $11.95.

Comparison with 3-in-1 monitoring services – For those interested in monitoring your credit report constantly, chances are that you would prefer a service that monitors all three credit bureau reports. Equifax has their own Equifax Credit Watch™ Gold with 3-in-1 Monitoring, which monitors and alerts you to changes in all three credit reports but not your score. In addition, you will get unlimited access to your Equifax credit report and $1,000,000 in ID theft insurance. The cost is $12.95 a month for this service.

TransUnion also has their equivalent of 3-in-1 credit monitoring service that comes at a price of $14.95 a month. Experian has a similar deal.

Verdict – One of the things that I really like about the Equifax ScoreWatch™ is that you can access your Equifax score twice a year (rather for 60 days). This feature is absent for example in TransUnion’s own credit monitoring service. However, I suspect that that those who are really interested in monitoring their credit would want to do so with all three credit bureaus rather than just one. If that is the case, then I would suggest you try the Equifax Credit Watch™ Gold with 3-in-1 Monitoring. It cost a bit more ($12.95 a month rather $9.95) and you cannot see your scores. But for credit monitoring purposes, it is cheaper than the alternatives offered by TransUnion and Experian.

Credit Hacking and More United Cards (Groan)

By: Jason Steele

08/03/2009

I am always on the lookout for new idea in the world of credit and reward cards. Sometimes they appear in the most unlikely places.

Wired Magazine Discovers “Credit Hacking”

Wired Magazine is a cutting edge publication that discusses the latest innovations in computers and technology. That is why I was surprised that they had published an article on not just “credit hacking” but “legal” credit hacking.

The idea is not that you would gain unauthorized access to your credit score, but that you can use what is known about the credit scoring process to legally manipulate it.

To be sure, I do not advocate or practice these methods, I am merely fascinated that they exist.

The article points out that this is the same person who popularized a known loophole in the whole “show me your boarding pass” operation that you go through at airport security. He created a website that merely changes your name on the boarding pass that you print at home. He pointed out that you could go through security with the altered pass and your ID, while showing the unaltered pass, without ID, when you board your flight. It was simple stuff, but the FBI had words with him for merely pointing out the known fallacies of the existing system.

More United/Chase Cards

Chase has reintroduced their United MileagePlus cards, this time with a bunch of options. You can see them here. The basic idea is that they give you the option of several different cards with significant benefits rolled in. For example, for $375 you can get a card with a Red Carpet Club lounge pass. Normally that pass is $525 by itself, so one would be crazy to purchase it by itself. Other possible benefits include “Economy Plus” upgrades, 30,000 bonus miles, and triple miles on United purchases.

I applaud Chase for developing thees innovative new products. They are consistent with my prediction that credit card companies will offer rewards that have little marginal cost associated with them, like access to a the “Red Carpet Clubs”.

Unfortunately, flying on United remains an excruciating experience, and attempting to redeem rewards is even worse. The problem is called StarNet Blocking, and it is a dishonest way of crippling your access to partner awards. Recently, a some frustrated travelers put up this site detailing the practice.

Until United gets their act together operationally, and stops their practice of Starnet Blocking, my recommendation is to avoid both United and their credit cards. If you must fly them for some reason, accrue miles in one of their partners, US Airways.

Carnival of Debt Reduction – The Federal Debt and Deficit Problem Issue

By: Mr Credit Card

While there are lots of personal finance bloggers who have successfully got out of debt, preach frugality, talk about how to make more money, the federal government has been pissing away our tax dollars and racking up huge debt that our future generations will have to bear in the form of massively higher taxes. They are robbing the future generation to pay the present generations massive entitlement program (which mostly started from legislation in the 1930s – and yet we talk so much about how great Hoover was!). It is kind off likely identity theft where your ID is used to open multiple credit cards and before you know it, you have incurred debt because of ID theft! But unlike where it can be reported, you can’t really report this to any authority.

This carnival is dedicated to all personal finance bloggers out there for preaching sound money principals – chiefly to spend less than we earn. This, the federal government has failed to do for years. I do not care if you are a republican or democrat, the truth is that the US is headed for a massive meltdown if we cannot face our debt problems. For those who have, you know that sacrifice is important. But it looks like we do not have will to face our problems. No politician can ever be elected if he says we’ll cut medicare or social security. Changes will be forced upon us only when “the shitteth hath hitteth the fan”.

So here is a Q&A about our financially incompetent government.

When was the last time the United States had no debt?

Answer – Back in 1836. Between 1792 to 1834, the United States was slowly able to reduce the size of their debt relative to GDP from 35% to 0% in 1836. At that time Andrew Jackson was the president of the United States. Since then until today, we have racked up close to 12 trillion. Will we ever be debt free again?

I don’t know the question to that one, but a couple of folks here have just become debt free and had their Credit Card is paid off. Here is another get out of debt story.

When did the US federal deficit and spending really got out of control?

Answer – Can’t pinpoint an exact year. But since the early 70s, we as a nation have been spending like there is no tomorrow! Take a look at the chart below (yes, the data is from 1792). It is in billions! Our fore fathers must be tossing and turning in their graves. Perhaps the federal government (executive branch and congress) needs some tools. I’m not too sure if YNAB – You Need A Budget is of any help to the federal government! Maybe America just ain’t good with budgeting. Heck, even Microsoft Money decided to pull out of the market though there are many budgeting tools and software still available.

federaldeficit

The 70s marked the end of the Brentton Woods Gold standard the the world had been operating on. In fact, for over 4 centuries, the world’s major superpowers and economies had more or less been running on gold standard. It was only since Nixon took us off the gold standard has the world been operating on floating currencies. The end of the gold standard also marked the era of modern day central bank press printing money, inflationary monetary policies, fooling us that we are wealthier than we think we are!

Why doesn’t the United States run a budget surplus and save, like every personal finance guru advocate?

The reason is that we are able to get away with it. How? Since we were the victors of World War 2, as part of the Brenton Woods agreement (aside from the gold standard), all international trade was to be denominated in US Dollars. Ever wondered why oil, gold, corn, orange juice or any commodity for that matter is traded in US Dollars? Look at it this way, when someone from say Italy wants to something in dollars, he or she has to have earned enough Lira (or Euros today) to convert them to US Dollars. Then he could them. But for us, we our currency. We do not have to convert them to anything. The folks who save (or rather have trade surplus – export more than import), have their savings in dollars because everyone trades in dollars. The only viable place to invest in US Government debt. Hence, that is the reason we are able to run persistent deficits (violating all personal finance rule #1 – spend less than you earn). If our currency is not the global currency, we would not have been able to get away with this. Perhaps this is the winners curse?

Can’t the Federal Government cut spending, we pf bloggers have lots of ideas for them!

Yeah, I know everyone has some ideas to cut spending. Maybe we should get officials to read the festival of frugality every week! But looks here, curbing your summer spending by 56%, going to college with less, go DIY and save money, cutting your TV bills, saving money on bank fees and other money saving tips ain’t going to put a dent in the federal deficit.

To do that, we probably need to do drastic things like make social security not pay as you go. And drastically cut back on medicare spending and entitlement. So in fact, if you are voting on drastically reducing the federal deficits, you are talking about massive entitlement reform (and potentially screwing your parents!). Politicians cannot get elected because older folks vote in greater numbers because they have more at stake.

Here is a pie chart for the Federal Budget for 2009 (courtesy of wikipedia) – Medicare, Social Security and Defence forms the largest components. Medicare expense is projected to grow the fastest!

budget

Maybe Drastic Cuts in Spending are not the way, maybe we need a plan for debt reduction over the long haul?

With 12 trillion in debt, how long does it take? Not too sure if a bankrate calculator can help on this. Dave Ramsey’s has his baby step method, you know, the tortoise and the hare method. But to be honest, I’m not sure we we will ever be getting out of debt at that rate! In the government bond market, snow flaking simply does not work. You have to redeem debt with the nearest maturities and they are the ones with the lowest interest rates, and with the most issuance. So whatever snowball or snowflake methods can be thrown out of the window!

Why do other countries have sovereign wealth funds and we do not?

Because we do not save, that’s why. How can we save if we have been constantly running a budget deficit? China exports more than it imports. The middle east have surplus revenues from oil. All Asian countries who went through the Asian crisis have saved and have huge foreign reserves. We have nothing! Nada! Zip! but just future social security and medicare obligations! In the personal finance world, there is always a debate about how much of our savings should be used for debt reduction versus emergency fund savings. The federal government does not save and hence this is an irrelevant question. The United States has no savings – check out the list of largest sovereign funds according to pioinline.com

sovereignfund

sovereignfund2

Why do we have to borrow from countries like China?

Because just as our federal government does not save, we as the voter, people, consumers do not save enough as well. Japan has an even large debt problem than us (ie debt to GDP). The reason the never had a problem funding their national debt is because the are a nation of savers. The government can borrow from their own people. We can’t even borrow from ourselves first because we as a people do not save enough! Federal borrowing exceeds personal savings. There is only so much treasuries a PIMCO total return fund can !

Why are we still able to borrow money relatively cheaply?

Reason is probably because our federal debt is rated triple A by Moodys and S&P and Fitch (although they did rate a lot of sub prime mortgage CDOs triple A at one stage too). The US government is perceived to the the safe investment in the world with the least risk of default. An emerging country may have its debt rated triple B and it will command a risk premium over US treasuries. In the 1800s when the US was an emerging economy, there were periods when our debt was trading at 6% (low yield for an emerging economy) but was 3% higher than the then “safer British debt”. Hence, a triple A rating from the rating agencies plus a perceived “safest asset” perception ensures we can borrow at low rates (just like how your fico score can also impact your borrowing cost). On a personal level, your credit score can also affect your career.

How if countries lose confidence in the US ability to run a sustainable budget, all bets are off. Countries that saw a massive devaluation in their currencies saw domestic interest rates rise to as high as 20% can you imagine what that sort of mortgage rate will do to your home value?

Is there a chance of the US government ever defaulting on its debt?

There is always a chance. But like consumers and individuals, sovereign nation states have other options. They can print money and devalue their currency (perhaps that’s the route that we are headed for – FDIC insurance will mean nothing if your currency can’t anything!). Typically, sovereign states can negotiate with their creditors (without having to go to a chapter 13 hearing!) to take a hair cut and exchange their debt for new terms.

Sovereign states do not need helpful debt settlement hints. They speak to investment bankers. Unlike most debt settlement companies that fail their clients, investment bankers are most of the time able to reissue and exchange debt on their behalf.

What if the world decides not to use the US dollar as the international currency?

The world already does not want to use the US dollar but it has no choice because there is no other real viable alternatives. It’s been close to 40 years since we left the gold standard that no modern central banker knows how to operate one even if we went to sound money rather than fiat money. But the fact that China has made arrangements with Brazil to trade in their own currencies are already debt warning signs that this might happen in the long haul. If the world were to suddenly not trade in US dollars, then there would be a flood of US dollars on the market because nobody wants them and nobody needs them if you have to goods in other currencies. Because of the massive supply, we will face massive inflation (in dollar terms) and also devaluation as there is no reason to hold a non-international currency. Interest rates will rise massively because bondholders will demand a risk premium, mortgage rates will go up, housing prices reprice again and banks have to mark down more assets again. You might want to consider having some inflation protected investments for yourself.

Can’t politicians come up with a plan to reduce our debt once and for all?

We certainly need them to be talking about it. Just as it would be nice to clear your personal debt and have a calm life, it would be great if we were a creditor nation again. Imagine that you pay off your mortgage, how can you do with that extra money in hand. But just imagine if you had just taken on a mortgage, the thought of having to pay someone for another 30 years is just too much for me. Imagine if you had to pay less taxes!

With the federal debt situation, it’s more like your grandchildren may have to pay for their mortgage too. Having said that, I hold up little hope for now. Our constitution is designed to be a gridlock system. Unless there is a crisis, like the US dollar losing its international currency status, little will change. We will probably pass a health care bill even if we cannot afford it! Yes, the system is broken and needs repair. But hey, when you are broke, you drive your 15 year car unless it reaches 250,000 miles or it dies on you. The federal government just doesn’t take advice like how to survive a recession. Their answer is to keep printing money and spend. And also borrow!

Many of us seem to be able to stop using credit cards irresponsibly, but not the federal government. The sad thing is that debt and credit are so much part of our lives today