In the last post, we talked about the investing mindset of relating complex investments into simpler, more understandable ideas. We took the example of the federal government’s budget and scaled it down into the budget for a typical middle class family. I left you with the cliff-hanger of what would have to be done to get the federal government in a position to dig itself out of debt.

There is not one answer to this question. The number of possible remedies is really only limited by how you want to do the math. Anyone in a difficult situation like this could benefit from another investing mindset rule:

A good investor makes decisions first by numbers
and secondly by emotions.

So, where do we start with this problem?

Well, the first place we could start is to ask the family/government how it is spending its money. The latest government financial report provides this answer:

For simplicity, we will assume all of these expenses total $154,000. Scaling everything down we see the following breakdown.

2011 U.S. Government Scaled-Down Budget

Medicare/Medicaid: $37,000
Other: $35,420
Social Security: $32,000
Defense: $31,000
Interest on the Debt: $10,780
Military pensions:$7,700

When I play around with these numbers myself, treating the government like a family with a spending problem, I notice a couple of interesting things. First, if you try to start paying down our national debt at even a modest pace over 30-40 years, you necessarily have to start making cuts of about 50% to all existing government programs. Secondly, even if you increase taxes substantially just to cover paying down the debt and supporting all existing programs, there gets to be an effective limit at which you can no longer tax enough to support the existing programs. From my point of view, I don’t see how anyone can fix the U.S. government budget without both raising taxes and decreasing benefits.

Next, we can see what the experts in each of the political parties are proposing.

• Click to see a quick summary of proposals from three different viewpoints: the Tea Party, the latest Republican proposal and President Obama’s draft budget.

There are a million different ideas about how to get the country’s finances on a sustainable path. The one thing all parties seem to agree on is that things can’t keep going on the way they are. Something has to change. There are three key things I think we all need to remember about this budgeting process.

1) Regardless of the budget decisions ultimately made, the government has to get its currently dysfunctional financial and accounting systems organized.

The U.S. has made some terrible financial decisions over numerous years and has yet to fully account for all of these mistakes. Take for example, these shocking quotes from Comptroller Dodaro in the government’s latest financial report:

“Three major impediments continued to prevent us from rendering an opinion on the accrual-based consolidated financial statements: (1) serious financial management problems at the Department of Defense (DOD) that have prevented DOD’s financial statements from being auditable, (2) the federal government’s inability to adequately account for and reconcile intragovernmental activity and balances between federal entities, and (3) the federal government’s ineffective process for preparing the consolidated financial statements.”

“Based on our review of completed Material Differences Reports for fiscal year 2011, we continue to note that amounts reported by federal entity trading partners for certain intragovernmental accounts were not in agreement by significant amounts. We noted that a significant number of CFOs continue to cite differing accounting methodologies, accounting errors, and timing differences for material differences with their trading partners. Some CFOs indicated that they did not know the reason for the differences. In addition, some CFOs confirmed the balance or activity, however, differences continued to exist. Further, there continue to be hundreds of billions of dollars of unreconciled differences between the General Fund of the U.S. Government and federal entity trading partners related to appropriation and other intragovernmental transactions.” (emphasis added)

“As in previous years, Treasury did not have adequate systems and personnel to address the magnitude of the fiscal year 2011 financial reporting challenges it faced, such as control deficiencies in its process for preparing the consolidated financial statements noted above. We found that personnel at Treasury’s Financial Management Service had excessive workloads that required an extraordinary amount of effort and dedication to compile the consolidated financial statements. Further, there were not enough personnel with specialized financial reporting experience to help ensure reliable financial reporting by the reporting date. In addition, the federal government does not perform interim compilations at the governmentwide level, which leads to almost all of the compilation effort being performed during a condensed time period at the end of the year.”

If you are familiar with financial statements, you would know that these seemingly boring, technical quotes have massive implications. They are really shocking! CFOs typically sweat bullets over any notes to the financial statements that even hint that a company is mismanaging its money. These notes outright state that the government has “serious financial management problems,” “control deficiencies,” “hundreds of billions of dollars of unreconciled differences” and is “ineffective.” Also, the words “As in previous years” is put in front of a terrible statement about the Treasury Department’s lack of financial capability as though the Treasury Department thinks it is acceptable to continue not to address these problems. If a corporation issued financial statements anything like this, the company would probably be automatically delisted from the stock market and likely sued perhaps even with criminal charges. It really is that bad.

So, no matter which budget path we choose, we should at least have the integrity to admit to our bad choices and the intelligence to execute our complex choices and properly and fully account for whatever it is that we have done. This has to be a top priority for any political party.

When you look at the three proposals above, the Tea Party seems to say that they are going to address this problem by eliminating any complicated financial transactions by cutting the government down severely. Both the Republican and Democratic parties would do well to add a line item to their budgets for additional accounting and financial management personnel.

2) We have to make a decision about what to do with our debt.

The budget proposals from the three political parties make radically different choices when it comes to the national debt. If you are trying to relate the government’s finances to your own, this is where the biggest disconnect occurs. If you fail to pay your mortgage, credit card, etc. there are big consequences for you. If the government fails to pay, it doesn’t seem to matter at all. There is seemingly endless credit for the government.

The Tea Party’s proposal is kind of like declaring liquidation bankruptcy with regard to the debt and quickly strikes to erase the debt in 5 years while political will remains intact. While you can disagree with these tactics, it probably is true that if you really wanted to erase the debt, you would have to do it quickly. The Republicans take a less aggressive approach and start cutting spending slowly, starting to pay down the debt almost 30 years into the future and who knows when, if ever, it would be paid off in full. All you would need is one intervening war, economic crisis or other problem to throw that spending plan off. The Democrats also cut spending slowly but sadly don’t seem to ever start paying down the debt, even with large tax increases.

3) The government is most likely on a slow path toward relinquishing its role as guarantor, forcing us all to
live with more financial uncertainty.

It is almost certainly true that the government can only get its finances in shape when it can adequately predict and control costs. It is probably only a matter of time before the government follows the trend in private industry to convert open-ended obligations to fixed price, limited time commitments.

Almost no private company makes these kinds of commitments any more. For example, companies found that promising employees pensions was too difficult to manage and required too much to be set aside in savings to guarantee payments so pension plans were converted to 401(k)’s. Likewise, we now have private health insurance programs that cap lifetime spending at a certain dollar amount. The government is really the only entity that operates without these constraints.

This is probably the biggest philosophical difference between the competing proposals. The Tea Party and the Republican Party force the government to operate like a private company. Open-ended programs like Medicaid would be converted to block grants to the states of limited dollar value. Once the money runs out each year, it is gone and people would have to do without unless private charity steps in. Likewise, converting Social Security to private accounts would do the same thing. Instead of your “Social Security pension” you would get the 401(k), which could be better or could be worse depending on how your investments perform. Converting people from Medicare to private health insurance will almost certainly result in dollar caps on care. The Democratic party maintains existing, unlimited systems but sadly, does not seem to have a sustainable way to afford them, even with significant, larger tax increases.

Worldwide, we are seeing many countries come to terms with the end of guaranteed programs. It requires us all to accept that the buffer on life’s uncertainty is gone. We could starve. We might have to make life-altering consequences about our health. We certainly have to take more responsibility to save, to make connections with other people who could help us, to maintain our diet and exercise and to do all sorts of other difficult things.

We can at least take comfort knowing that the future might not be dim, just different. After all, is there that much difference between having a Social Security 401(k) where the value goes up and down with the stock market or a guaranteed Social Security pension that gets cut 25% (or perhaps more) when the government runs out of money?

It is a good exercise in focused, logical investing discipline to look at each of these budget proposals and create your own game plan assuming any one of these strategies is enacted. How would they impact you?

When it comes to your own money, the same rational, numbers first, approach is essential. Money is complicated. It invites emotion. Money is the access key to all sorts of wonderful and essential things. Money is also the reminder of bad decisions or painful decisions we keep putting off.

The government’s budget struggle really has so many parallels to our individual lives. How do we plan for the future? How do we strike the balance between getting exciting things we want and covering the cost of boring, basic essentials like food, clothing and shelter. How do we do the day to day accounting necessary to make good decisions?

Do you struggle with maintaining rational thought when it comes to issues of money? What do you think of the pending budget proposals? Please share in the comments.