For the last 15 years, Bertha has made $50,000 per year but has spent $55,000. When she couldn’t afford things she wanted, she charged them to her credit card. The credit card carries an 8 percent interest rate, so she’s now in debt to the tune of $100,000.
Bertha has now realized the error of her ways and has come to you for advice. What should she do to fix the problem?
First, you would probably tell her to stop spending $55,000 when she only earns $50,000. Unfortunately, that alone doesn’t solve Bertha’s problem because she also has to pay the interest on the credit card ($100,000 x 8 percent = $8,000) in order to stop the debt from growing.
Your advice, then, is to tell her to shrink her spending from $55,000 down to $42,000. This is a 30 percent cut in spending and still doesn’t start paying off the principal.
What happens if Bertha can only reduce her spending down to $46,000? Her debt balance goes up to $104,000 which means that next year’s interest payment will be $104,000 x 8 percent = $8,320. Unless Bertha can get down to some number below $42,000, the fact is that the interest payment will grow until it ultimately absorbs all of her budget. She’ll be bankrupt.
Mayor Sanders met Bertha right after he was elected. She’s the city of San Diego. While the numbers are obviously different, the proportions are actually pretty close. The mayor and his team have done a yeoman’s job of decreasing costs … but the fact is that we’re only about down to (Bertha’s) $46,000 mark. We aren’t yet to the point of paying off any principal; our debt is continuing to grow.
Now let’s say that Bertha gets a 6 percent raise (about the amount that the city’s income increases each year). Next year she will make $50,000 x 106 percent = $53,000. Good news! If she can hold her spending to $46,000, that should give her $7,000 to put toward that $8,320 interest payment. The debt is still worsening, but at a slower rate. If her income keeps increasing and she holds her expenses constant, she actually could grow out of the problem.
Does anyone really believe that Bertha will hold her spending constant? And more to the point … does anyone think the city is holding its expenses constant? Nope. We have backloaded pay raises from the old administration and new pay raises from the current administration. Do the employees deserve the raises? I’m sure they do. But if new expenses eat up all of Bertha’s $3,000 pay raise, she’s back adding to her debt … which adds to the interest payment … which pushes her closer to the edge of bankruptcy.
That’s why it’s so important for the council to hold the mayor’s line on spending. They simply cannot backpedal on the cuts he’s proposing.