Economic Lessons that Even a Fifth Grader Can Understand

“The Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” —    Ronald Reagan

Jeff Foxworthy became famous and made a fortune with Red Neck jokes and comedy tours. He’s parlayed his notoriety and down-home humor into a popular game show called “Are You Smarter than a 5th Grader?” You can test your 5th-grade knowledge with an online ten-question test. The show has proved to be hugely popular. I doubt that the questions on the show accurately reflect what is being taught in the typical 5th grade classroom. If it is, then most 5th graders aren’t remembering much of it.

How many times have we been told that two years of algebra, a year of geometry, and one year of either trigonometry or calculus are crucial for the salvation of our Republic? I have no doubt that knowledge of these courses is essential in a number of highly specialized fields. I also have no doubts that after high school the majority of Americans never use anything beyond simple mathematics, and even here I have some doubts.

For most of us, there is very little call for higher mathematics. You certainly don’t have to be a math wizard to understand the math behind everyday economic transactions. There are many Americans who believe that the downturn in the economy is complicated and that capitalism is the culprit and has been discredited. The credit crisis was not the fault of capitalism but with anti-capitalism brought on by government intervention. Congress created an economic fiction by subsidizing loans that no bank or mortgage company would have done if there had not been financial institutions behind them insuring the bad loans they were making. But how do you explain this so a fifth grader can understand it?

Let’s say that three fifth graders want to purchase the latest hot game for PlayStation and they heard that a fifth grade friend of theirs got $500 for Christmas. Each of them wants to borrow $50 for the new game. The first fifth grader says that he has a job mowing lawns and will be able to pay back the loan at the end of the summer. The second fifth grader gets a weekly allowance for doing his chores. No chores, no allowance. The same end-of-summer promise is made. The third fifth grader has a job walking dogs and babysitting, but she can guarantee that her parents will pay back the $75 at the end of the summer whether or not she can raise enough cash.

The first borrower has less risk than the second borrower, but what if there is a drought and people don’t need their lawns mowed? To account for this contingency, the borrower has some items he can sell on eBay that are worth more than $100. He has collateral. The second borrower has the greatest risk since he has no collateral to back up the loan if he defaults. There is almost no risk with the third borrower since the loan is guaranteed by a reliable third party. The only risk the third borrower brings is her parents might lose their jobs and move away. Even so, the small amount of the loan almost assures the $50 will be paid back. Even a fifth grader can understand that the third borrower is the least risky investment.

The mortgage debacle in America came to fruition because of promised government loan guarantees insured by assets from the VA, FHA, Freddie Mac (Federal Home Loan Mortgage Corporation), and Fannie Mae (Federal National Mortgage Association). It was the promise of the guarantee that made lending to high risk borrowers attractive to banks and other lenders. There was no perceived risk. The transactions seemingly only had an upside. As long as there is a guarantor, as in the case of a parent who will guarantee a $50 loan of government agencies with an unending source of capital, there was no incentive to scrutinize borrowers. Even a 5th grader can understand this. It’s too bad that a majority of our elected officials are still stuck in the 3rd grade.