The Opportunity Cost of Debt

Posted by PITHOCRATES - September 16th, 2013

Economics 101

Housing Sales drive the Economy because almost Everything for Sale is for the Household

Once upon a time the rule of thumb was to buy the most expensive house we could possibly afford.  We saved 20% for a down payment on a conventional mortgage.  We lived on a shoestring budget and paid our mortgage no matter what.  Even if we had to live on meatloaf and macaroni and cheese for the next five years.  Or longer.  We did this because we would be paying that mortgage payment for 30 years.  And though tough at first during those 30 years we advanced in our careers.  And made more money along the way.  Making that mortgage payment easier to pay as time went by.

So that was the way it used to be.  And it was that way for a long time.  Until the Federal Reserve started playing with interest rates to stimulate economic activity.  Altering the banking system forever.  Instead of encouraging people to save their money so banks could loan money to homebuyers they printed money.  Flooded the market with it.  Ignited inflation.  And caused housing bubbles.  Then the government took it up a notch.

Housing sales drive the economy.  Almost everything for sale is for the household.  Furniture and appliances.  Beds and ceiling fans.  Tile and paint.  Cleaning supplies and groceries.  Dishes and cutlery.  Pots and pans.  Towels and linen.  Lawnmowers and weed-whackers.  Decks and patio furniture.  When people buy a house they start buying all of these things.  And more.  Creating a lot of economic activity with every house sold.  So the government did everything they could to encourage home ownership.  And few governments did more than the Clinton administration.  By applying pressure on lenders to qualify the unqualified for mortgages.  Which gave us the subprime mortgage crisis.

Lenders used Subprime Lending to Qualify the Unqualified to Comply with the Clinton Administration

People in poor neighbors tended to be poor.  And unable to qualify for a mortgage because they couldn’t afford the house payments.  When these poor people happened to be black the Clinton administration said the banks were racist.  They were redlining.  And advised these lenders that if they don’t start qualifying these people who couldn’t afford a house that the full weight of the government will make things difficult for them to remain in the lending business.  So they complied with the Clinton administration.  Using subprime lending to put people into homes they couldn’t afford.

The main reason why people can’t afford to buy a house is the size of the mortgage payment.  Which can be pretty high if they can’t afford much of a down payment.  So these lenders used special mortgages to bring that monthly payment down.  The adjustable rate mortgage (ARM).  Which had a lower interest rate than conventional mortgages.  Because they could raise it later if interest rates rose.  Zero-down mortgages.  Which eliminated the need for a down payment.  Coupled with an ARM when interest rates were low could put a poor person into a good sized house.  No-documentation loans.  Which removed the trouble of having to document your earnings to prove you will be able to make your house payment.  Making it easier to approve applicants when you don’t have to question what they write on their application.  Interest-only loans where you only had to pay the interest for, say, 5 years.  Greatly reducing the size of the monthly payment.  But after those 5 years you had to pay that loan back in full with a new mortgage for the full value of the house.  Which may be more costly in 5 years.

So these lenders were able to meet the Clinton administration directive.  They were putting people into homes they couldn’t afford.  Just barely.  These people had house payments they could just barely afford.  Thanks to the low interest rate of their ARM.  But then interest rates rose.  Making those mortgage payments unaffordable.  With zero-down they had little to lose by walking away.  And a lot of them did.

The Interest on the Debt is so large we have to Borrow Money to Pay for the Cost of Borrowing Money

Buying a house is a huge investment.  One that we finance.  That is, we borrow money.  Sometimes a lot of it.  Because we don’t want to wait and save money for a down payment.  And because we want so much right now we buy as much as we can with those borrowings.  Doing whatever we can to lower the monthly payment.  With little regard to long-term costs.  For example, assume a fixed 30-year interest rate of 4.5%.  And we finance a $150,000 house with zero down.  Because we have saved nothing.  The monthly payment will be $790.03.  But if we waited until we saved enough for a 10% down payment that monthly payment will only be $684.03.  And if we saved enough for 20% down the monthly payment will only be $608.02.  That’s $182.01 less each month.  The total interest paid over the life of this mortgage for zero down, 10% down and 20% down is $123,610.07, $111,249.06 and $98,888.05, respectively.  Adding that to the price of the house brings the total cost for that house to $273,010.07, $246,249.06 and $218,888.05, respectively.  So if we wait until we save a 20% down payment we will be able to buy a $150,000 house and $54,723.02 of other stuff during those 30 years.  This is the opportunity cost of debt.

We are better off the less we finance.  Because long-term debts are with us for a long time.  And they don’t go away if we lose our job.  Or if interest rates go up.  Like with an ARM.  A large driver of the subprime mortgage crisis.  Let’s see what was happening before the housing bubble burst.  Let’s say we could buy that $150,000 house with a zero down mortgage with an adjustable interest rate of 2%.  Giving us a monthly payment of $554.43.  Very affordable.  Which helped get a lot of people into houses they couldn’t afford.  But then the interest rate went up.  And what did that do to someone who could just barely pay their house payment when it was $554.43?  Well, if it reset to 4% that payment increased to $716.12 ($161.69 more per month).  If it reset to 6% that payment increased to $899.33 ($344.90 more per month).  Bringing the total cost of the house to $323,757.28 ($150,000 principle + 173,757.28 interest).  Which is why a lot of these people walked away from these houses.  There was just no way they could afford them at these higher interest rates.

Interest payments on long-term debt at high interest rates can overwhelm a borrower.  Making the Clinton administration’s Policy Statement on Discrimination in Lending insidious.  It destroyed people’s lives.  Putting them into houses they couldn’t afford with subprime lending.  But if you think that’s bad consider the national debt.  These are long-term obligations just like mortgages.  And currently we owe $16,738,533,025,135.63 (as of 9/13/2013).  At an interest rate of 3.9% the annual interest we must pay on this debt comes to $652,802,787,980.29.  That’s $652.8 billion.  Which is more than we spend on welfare ($430.4 billion).  Almost what we spend on Social Security ($866.3 billion).  And more than half of the federal deficit ($972.9 billion).  This is the opportunity cost of debt.  It limits what we can spend elsewhere.  On welfare.  Social Security.  Etc.  The interest on the debt has grown so large that we even have to borrow money to pay for the cost of borrowing money.  And there is only one way this can end.  Just like the subprime mortgage crisis.  Only worse.

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Generator, Current, Voltage, Diesel Electric Locomotive, Traction Motors, Head-End Power, Jet, Refined Petroleum and Plug-in Hybrid

Posted by PITHOCRATES - June 6th, 2012

Technology 101

When the Engineer advances the Throttle to ‘Run 1’ there is a Surge of Current into the Traction Motors

Once when my father suffered a power outage at his home I helped him hook up his backup generator.  This was the first time he used it.  He had sized it to be large enough to run the air conditioner as Mom had health issues and didn’t breathe well in hot and humid weather.  This outage was in the middle of a hot, sweltering summer.  So they were eager to get the air conditioner running again.  Only one problem.  Although the generator was large enough to run the air conditioner, it was not large enough to start it.  The starting in-rush of current was too much for the generator.  The current surged and the voltage dropped as the generator was pushed beyond its operating limit.  Suffice it to say Mom suffered during that power outage.

Getting a diesel-electric locomotive moving is very similar.  The massive diesel engine turns a generator.  When the engineer advances the throttle to ‘Run 1’ (the first notch) there is a surge of current into the traction motors.  And a drop in voltage.  As the current moves through the rotor windings in the traction motors it creates an electrical field that fights with the stator electrical field.  Creating a tremendous amount of torque.  Which slowly begins to turn the wheels.  As the wheels begin to rotate less torque is required and the current decreases and voltage increases.  Then the engineer advances the throttle to ‘Run 2’ and the current to the traction motors increases again.  And the voltage falls again.  Until the train picks up more speed.  Then the current falls and the voltage rises.  And so on until the engineer advances the throttle all the way to ‘Run 8’ and the train is running at speed. 

The actual speed is controlled by the RPMs of the diesel engine and fuel flow to the cylinders. Which is what the engineer is doing by advancing the throttle.  In a passenger train there are additional power needs for the passenger cars.  Heating, cooling, lights, etc.  The locomotive typically provides this Head-End Power (HEP).  The General Electric Genesis Series I locomotive (the aerodynamic locomotive engines on the majority of Amtrak’s trains), for example, has a maximum of 800 kilowatts of HEP available.  But there is a tradeoff in traction power that moves the train towards its destination.  With a full HEP load a 4,250 horsepower rated engine can only produce 2,525 horsepower of traction power.  Or a decrease of about 41% in traction horsepower due to the heating, cooling, lighting, etc., requirements of the passenger cars.  But because passenger cars are so light they can still pull many of them with one engine.  Unlike their freight counterparts.  Where it can take a lashup of three engines or more to move a heavy freight train to its destination.  Without any HEP sapping traction horsepower.

There is so much Energy available in Refined Petroleum that we can carry Small Amounts that take us Great Distances

The largest cost of flying a passenger jet is jet fuel.  That’s why they make planes out of aluminum.  To make them light.  Airbus and Boeing are using ever more composite materials in their latest planes to reduce the weight further still.  New engine designs improve fuel economy.  Advances in engine design allow bigger and more powerful engines.  So 2 engines can do the work it took 4 engines to do a decade or more ago.  Fewer engines mean less weight.  And less fuel.  Making the plane lighter and more fuel efficient.  They measure all cargo and count people to determine the total weight of plane, cargo, passengers and fuel.  So the pilot can calculate the minimum amount of fuel to carry.  For the less fuel they carry the lighter the plane and the more fuel efficient it is.   During times of high fuel costs airlines charge extra for every extra pound you bring aboard.  To either dissuade you from bringing a lot of extra dead weight aboard.  Or to help pay the fuel cost for the extra weight when they can’t dissuade you.

It’s similar with cars.  To meet strict CAFE standards manufacturers have been aggressively trying to reduce the weight of their vehicles.  Using front-wheel drive on cars saved the excess weight of a drive shaft.  Unibody construction removed the heavy frame.  Aerodynamic designs reduced wind resistance.  Use of composite materials instead of metal reduced weight.  Shrinking the size of cars made them lighter.  Controlling the engine by a computer increased engine efficiencies and improved fuel economy.  Everywhere manufacturers can they have reduced the weight of cars and improved the efficiencies of the engine.  While still providing the creature comforts we enjoy in a car.  In particular heating and air conditioning.  All the while driving great distances on a weekend getaway to an amusement park.  Or a drive across the country on a summer vacation.  Or on a winter ski trip.

This is something trains, planes and automobiles share.  The ability to take you great distances in comfort.  And what makes this all possible?  One thing.  Refined petroleum.  There is so much energy available in refined petroleum that we can carry small amounts of it in our trains, planes and automobiles that will take us great distances.  Planes can fly halfway across the planet on one fill-up.  Trains can travel across numerous states on one fill-up.  A car can drive up to 6 hours or more doing 70 MPH on the interstate on one fill-up.  And keep you warm while doing it in the winter.  And cool in the summer.  For the engine cooling system transfers the wasted heat of the internal combustion engine to a heating core inside the passenger compartment to heat the car.  And another belt slung around an engine pulley drives an air conditioner compressor under the hood to cool the passenger compartment.  Thanks to that abundant energy in refined petroleum creating all the power under the hood we need.

The Opportunity Cost of the Plug-in Hybrid is giving up what the Car Originally gave us – Freedom 

And then there’s the plug-in hybrid car.  That shares some things in common with the train, plane and (gasoline-powered) automobile.  Only it doesn’t do anything as well.  Primarily because of the limited range of the battery.  Electric traction motors draw a lot of current.  But a battery’s storage capacity is limited.  Some batteries offer only about 20-30 miles of driving distance on a charge.  Which is great if you use a car for very, very short commutes.  But as few do manufacturers add a backup gasoline engine so the car can go almost as far as a gasoline-powered car.  It probably could go as far if it wasn’t for that heavy battery and generator it was dragging around with it.

This is but one of many tradeoffs required in a plug-in hybrid car.  Most of these cars are tiny to make them as light as possible.  For the lighter the car is the less current it takes to get it moving.  But adding a backup gasoline engine and generator only makes the car heavier.  Thus reducing its electric range.  Making it more like a conventional car for a trip longer than 20-30 miles.  Only one that gets a poorer fuel economy.  Because of the extra weight of the battery and generator.  Manufacturers have even addressed this problem by reducing the range of the car.  If people don’t drive more than 10 miles on a typical trip they don’t need such a large battery.  Which is ideal if you use your car to go no further than you normally walk.  A smaller battery means less weight due to the lesser storage capacity required to travel that lesser range.  Another tradeoff is the heating and cooling of the car.  Without a gasoline engine on all of the time these cars have to use electric heat.  And an electric motor to drive the air conditioner compressor.  (Some heating and cooling systems will operate when the car is plugged in to conserve battery charge for the initial climate adjustment).  So in the heat of summer and the cold of winter you can scratch off another 20% of your electric range (bringing that 20 miles down to 16 miles).  Not as bad as on a passenger locomotive.  But with its large tanks of diesel fuel that train can still take you across the country.

The opportunity cost of the plug-in hybrid is giving up what the car originally gave us.  Freedom.  To get out on the open road just to see where it would take us.  For if you drive a long commute or like to take long trips your hybrid is just going to be using the backup gasoline engine for most of that driving.  While dragging around a lot of excess weight.  To make up for some lost fuel economy some manufacturers use a gasoline engine with high compression.  Unfortunately, high compression engines require the more expensive premium (higher octane) gasoline.  Which costs more at the pump.  There eventually comes the point we should ask ourselves why bother?  Wouldn’t life and driving be so much simpler with a gasoline-powered car?  Get fuel economy with a range of over 300 miles?  Guess it all depends on what’s more important.  Being sensible.  Or showing others that you’re saving the planet.

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Opportunity Costs

Posted by PITHOCRATES - June 4th, 2012

Economics 101

Those on the Left are all for Choice as long as you Choose what they want you to Choose

Choice.  It’s what life is.  Every day we make hundreds of choices in our life.  The communists called that a burden.  And that their way removed all that stress from our lives.  The stress of constantly having to choose.  They came up with a new freedom.  Freedom from choice.  To live under oppression.  Like a slave.  Where you no longer had the burden of making a choice every waking hour of your day.  You simply took what the government gave you.  And relaxed.  Truly free.

It turned out the people living under communism preferred having that burden of choice.  And took every opportunity to escape the communist ‘freedom’.  To a freedom where you were free to choose whatever you wanted.  Instead of taking what central planners gave you.  Those on the Left always had a soft spot in their hearts for communism.  And Soviet central planners.  For they never cared that much for free markets.  Laissez faire capitalism.  Freedom of choice.  Because people so often chose poorly in their opinion.  For they weren’t as educated and enlightened as they were on the Left.  And therefore chose the wrong kind of foods to eat.  The wrong kind of beverages to drink.  The wrong kind of cars to drive.  The wrong kind of power to generate.  And the wrong people to vote for.

No.  Those on the Left are no fans of choice.  Except, of course, when it comes to abortion.  When it comes to abortion then they are big fans of choice.  But not so much when it comes to us choosing what to eat, drink and drive.  Or how we generate our energy.  So when it comes to choice those on the Left are like the Soviet central planners.  They are all for choice.  As long as you choose what they want you to choose.

When making any Economic Decisions we make our Choice based on Opportunity Costs 

But we choose.  Because we can.  At least with most things.  But how do we choose?  Does price determine what we choose?  Sometimes.  Quality?  Sometimes.  Loyalty?  Sometimes.  Sometimes it’s one of these things.  Sometimes a combination of all of these things.  Sometimes it’s none of these things.  So what is it that makes up your mind when confronted with a choice?  Do you know?  You do.  For obviously you’re making the choice.  But the ‘why’ we may have to coax out of you.  For you will probably not be able to explain why.  At least not as well an economist can.

The study of economics is all about choice.  And trying to determine what influences people’s choices.  So economists can offer economic policies to maximize economic activity.  By maximizing that thing we ultimately trade for.  Which is what?  Happiness.  We choose to increase our happiness.  Or utility in the parlance of economics.  The things we choose are the things that will give us the greatest happiness.  Or the greatest utility.  But if you’re like me you never saw ‘utility’ or ‘happiness’ expressed as units on a price tag in a store.  Price tags show only price.  Which tells us little how happy something will make us.  So how do we choose the things that will maximize our happiness?  Especially if you’re looking at two different things that have the same price?

Easy.  We don’t make our decision by looking at what we’re buying.  We make our decision based on what we’re not buying.  What we are giving up by buying this thing or that service?  What might have been had it not been for this purchase?  What opportunity we’re passing on to make this purchase?  What cost are we paying in lost opportunity by committing to this purchase?  In other words, when making any economic decisions we make our choice based on opportunity costs.  On an amount of happiness we’re giving up to acquire some other amount of happiness.  And whatever the number of our choices the end result is the same.  What we choose gives us more happiness than all other possible alternatives.  Regardless of price, quality or loyalty.  Though they could influence us when there is a tie.

Liberals make us Buy not what Increases our Happiness but what Increases their Happiness

You can’t put a price on happiness.  That’s what they say.  And they are right.  Whoever they are.  For example, luxury cars are nice.  But they are expensive.  Subcompacts are not as nice as luxury cars.  But they are not as expensive either.  So if you were choosing between these two cars which one would you choose?  I can’t tell because I don’t know your income.  But I can guess at your decision process.  You’re going to compare opportunity costs.  Driving a luxury car gives you enormous amounts of happiness.  For the limited time you spend driving it.  Enormous happiness for a limited amount of time.  Okay.  But what are the opportunity costs?

Let’s say your daily commute to and from work is one hour.  But when you get home you enjoy 4 hours between surfing the Internet and watching cable television.  When you’re not at work or home you like to use social media on your smartphone interacting with your friends.  And using your smart phone apps to maximize your fun in the evenings and on the weekend.  You like to spend your Sunday mornings at the coffee shop with you tablet reading the online Sunday papers.  The hours of driving happiness come to 10 hours a week.  And the hours of online/watching cable happiness comes to 32 hours a week.  Now being that you spend more time online or watching cable than driving then it’s safe to say that driving brings you less happiness than those other activities.  Because luxury cars are expensive they come with a high monthly payment and a high insurance premium.  Which means you will have to cut back on other spending to afford the luxury car.  So to afford the luxury car you have to give up your cable and home Internet access.  And cut back on your minutes on your smartphone.

The opportunity cost of the luxury car is giving up cable TV and cutting back on Internet access and smartphone minutes.  The opportunity cost of keeping those things is getting a subcompact car instead of a luxury car.  This is the ultimate decision we make in all of our economic decisions.  Which will cost us more in sacrificed happiness in the long run?  Which makes those decisions easy.  In the above example you would probably have never given the luxury car any serious thought.  This is why free markets work so well.  Why laissez faire capitalism works so well.  Because the economy is full of individuals making these decisions quickly.  Far quicker than any Soviet state planner.  And with far more insight into our own wants and desires than any Soviet state planner.  And in the aggregate this drives economic activity.  Bringing the things we want to market.  The things that give us the greatest amount of happiness.  The things that have the lowest opportunity costs.  Unlike Soviet central planning.  Or American liberal Democrat central planning. 

No.  These people try to change our purchasing decisions.  Making us buy not what increases our happiness.  But what increases their happiness.  Which is why when liberal Democrats are in power there is a general economic decline.  Because they do alter our purchasing decisions.  By increasing the opportunity costs of the things that increase our happiness.  So that we buy fewer of them.  But we don’t buy more of the things they want us to buy.  Because those things don’t increase our happiness.  When they subsidize hybrid cars (paid for with higher taxes from us) to get us to buy them it doesn’t make the hybrid cars give us any more happiness.  It just leaves us with less money because of the higher taxes.  So we buy less of everything else.  And in the aggregate this lowers economic activity.  Leaving us all less happy.

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