This blog is the first in a series on public financial management (PFM). We start by identifying the principles of financial management from the experience of an individual. Later we will investigate how the personal and organisational interact.
Much of the focus of political discussions is on the budget surplus or deficit.
Figure 1 US Government Treasury Data 2015 https://www.mediamatters.org/sean-hannity/new-data-debunks-years-fox-news-paranoia-about-federal-budgetdeficit
But is this where politicians’, and our, attention should be?
Let me give you a personal example[1]: Let’s say I have income of $1000 a week. From that 10 percent is paid in income taxation and a further 10 percent into long term savings in the form on my superannuation contribution. That leaves me with $800 a week cash to allocate to my budgeted ends.
How many ways can I approach spending my $800?
- Put it in my purse or wallet and spend it on opportunities that arise until it’s gone. Then go without until the next payday and the next instalment of $800. If my rent is paid monthly, then for three weeks of the month I don’t pay anything to rent and in the fourth week, my entire cash income goes in rent. When bills arrive, for example my mobile plan bill, if it’s the same week as my rent, I’m skint. I then borrow to meet my obligations. Then, when my next $800 arrives, I have to repay my borrowings before I can spend. You can see where this goes. This is not a path to financial independence and wealth. What other options do I have?
- I push $500 into a bills account as soon as my pay arrives. It accumulates so that when the rent is due and the mobile plan bill is due, there is money there already, but some also for electricity and other bills. I spend the $300 on food and transport and entertainment and anything left over on clothes. If I want to save for a special purpose, that comes out of the current funds of $300 a week, perhaps $20 a week pushed into another account. Or…
- I push $100 into a long-term investment account, $500 into the bills account and use the $380 for food and weekly expenses with $20 into my special fund account.
- If I want to do interesting things later in the year, e.g. go to the beach for a week, then I find out how much that costs, and put funds aside so that, come the time, I have the funds available.
OK so that’s how we manage cash in and cash out in different ways.
But what does it tell me about my wealth? Not much. If I have a car that costs $200 a week to run, then that reduces my options. If I have a house that costs me $500 a week in mortgage repayments, again, my options change.
But if I have a garden, and use my time to make it beautiful, obtaining cuttings from friends and taking their scraps to turn into compost, I use my time to add value to my life. The garden comes from effort, not from cash. Even with cash, I can’t get the garden that I would make with my own effort. I can plant trees, raise seedlings and grow my vegetables, saving myself and improving my health. And working in the garden may keep me at home more, thus saving money I would otherwise spend on entertainment.
Similarly, if I’ve bought clothes and a car and paid bills on my credit card, I may have accumulated a debt, say of $10,000. This will take years to pay off, and in addition to repaying that which I borrowed, I have to pay the bank interest on my borrowings. Soon the $10,000 debt increases as interest is added. Google helpfully advises “If you pay $285 a month it will take you four years and nine months to pay it off and cost $6,165 in interest. But drop that rate to 12%, make the same monthly payment, and you’ll be out of debt one year and one month earlier and you’ll pay only $2,378 in interest.” So a $10,000 shopping spree can cost up to $6000 in interest, for the luxury of spending money I don’t have.
So you see now that looking only at income and expenses isn’t sufficient. You also need to know the assets you have to operate and maintain, and the liabilities you have to service.
So what is your net worth? A rich man with a house, a big car and an important job may actually be worse off than you are. He may, for example, owe over $1,135,000 on which he is paying interest. His assets may equal $950,000 including the second hand value of his car and the house. If he doesn’t maintain the car regularly and clean it, its value will decrease rapidly and he may still be paying it off well after it’s stopped being an asset, and has instead, turned into a liability. Similarly the house. If he spends his weekends repairing it, painting it and keeping it clean and tidy, he may increase its value. But if he doesn’t do that, the initial investment in a $900,000 may result in a house that now is valued at $750,000. Let’s compare the net worth of two people:
| Person A | Person B | |
| Income per year | 50,000 | 150,000 |
| Annual living expenses | -16,000 | -55,000 |
| Annual car expenses | -5,200 | -16,000 |
| Annual Housing expenses | -10,000 | -25,500 |
| Annual holidays | -3,000 | -25,000 |
| Net Income | 15,800 | 28,500 |
| Savings | -9,000 | -500 |
| Annual Christmas splurge | -800 | -10,000 |
| Birthdays and gifts | -1,000 | -10,000 |
| Income remaining in bank | 5000 | 8,000 |
| Borrowings | Nil | 950,000 |
| Assets | $5,000 | $900,000 |
| Net worth | $19,000 | -$41,500
|
So you can see that person A is wealthier than person B who carries debt and higher expenses. Yet, when looking at the income alone, Person B looks to be the wealthier, because s/he has a much higher income. But person A, having lower expenses, and by saving, is each year increasing their net worth.
Let’s look at this over time.
| Net Worth over time | Person A | Person B |
| Borrowings | Nil | $950,000 |
| Assets | $5,000 | $900,000 |
| Net worth – End of year 1 | $19,000 | -$41,500 |
| Net worth – End of year 2 | $38,000 | -$155,500 |
| Net worth – End of year 3 | $38,380 | -$329,660 |
| Net worth – End of year 4 | $57,763.80 | -$410,719 |
| Net worth – End of year 5 | $96,341.44 | -$501,506 |
| Net worth – End of year 6 | $135,684.85 | -$603,186
|
Within six years, Person A may have $135,000 saved earning 1% interest, and Person B’s debt may have increased to $1,575,000 as s/he pays 12% interest on borrowings, to which are added the negative net worth which he has to borrow to fund. Both savings and debts accumulate.
Person A is therefore $1.365 million dollars richer than person B.
Of course this is only an illustration. If the loan carried by Person B is a mortgage which increases in size as interest is incurred and repayments don’t cover interest charged, the negative net worth grows, widening the gap between Person A and B. And if person A borrows money s/he consumes the equity in his / her net worth. Thus, over time, things change, including income and expenditure. The above example assumes a consistent income and stable expenditure. This is unlikely.
This show us that, by concentrating on the budget deficit, being the difference between annual income and expenditure, we can be misled. By concentrating on expenditure and income, we do not have the whole picture. It is only by looking at the assets and liabilities that we get a real picture and can calculate net worth.
Then, in addition, if both people work hard on their garden, clean their cars regularly and make their home beautiful, person B may be happy to make the investment in money terms, because his family’s enjoyment is more than offset by the cost incurred. Similarly person A may have no enjoyment in life apart from seeing their bank balance grow. They may be lazy and their home a mess and their family miserable. All this although they have no worries about debt.
In the end, it isn’t how much money you earn, but the actions you take towards building your home and family that determine whether you are wealthy or not. Money alone cannot build wealth.
The Norwegian author, Arne Garborg, observed:
“For money you can have everything it is said. No, that is not true. You can buy food, but not appetite; medicine, but not health; soft beds, but not sleep; knowledge but not intelligence; glitter, but not comfort; fun, but not pleasure; acquaintances, but not friendship; servants, but not faithfulness; grey hair, but not honour; quiet days, but not peace. The shell of all things you can get for money. But not the kernel. That cannot be had for money.”
Nor will budgeting get you what you want unless you first focus on what is important to you and your family.
Next, we will discuss what is meaningful. Later we will identify the boundaries between money and wealth in our lives. Then, once our principles have been established, we will look at how the government manages its finances. This is a much more complex matter.
[1] Each blog will build on the previous one until we get a fuller picture of PFM.