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    Economic Theory - The Role of Credit
    By Gerhard Adam | July 21st 2009 10:53 PM | 4 comments | Print | E-mail | Track Comments
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    Let’s examine the demand side of the equation a bit more and explore the impact that credit has on an economy.

    There is no question that credit can provide a smoother flow of money through an economy to ensure that periodic starts and stops aren’t affected by variations in the cash flow. This is particularly important to ensure smooth operation in many companies as well as for individuals.

    Equally there is no question regarding the usefulness of credit for large capital expenditures that would otherwise be impossible to obtain, typically housing, cars, etc.

    However, when it comes to unsecured debt we have a different situation that bears some scrutiny. In particular, it should be recognized that credit is simply spending “future” money (or unearned money) to acquire goods and services. Therefore it is absolutely essential that credit not extend out much beyond the predictability of such future revenue being generated. When coupled with high interest rates, this creates a tremendous drain on the “demand” side of the economic arrangement.

    Another way to view this is to consider that there is a certain demand (X) that is available based on the amount of money that an individual earns; their disposable income. Therefore for equilibrium to be attained, there is a requirement that money flow between the demand and supply segments of the two environments. As the amount of credit increases, it behaves like a subsidized salary, creating an artificial rise in the demand. Unfortunately this can’t be sustained because the increase in available disposable income isn’t real. Eventually (coupled with interest rates), the money available for demand is focused on servicing debt and the accelerated availability of funds has caused a spike in supply that can’t be maintained either. In response to this artificial rise in demand, suppliers have created a glut of products for the market, resulting in a decline in economic equilibrium when credit availability freezes. At this point, the flow of money is detoured from the supply/demand side of the equation and, once again, the economy stops.

    It makes little difference about the initial benefit of acquiring the good and services early, because over time, the effect is diluted by the long-term costs of servicing the debt. What exacerbates this problem is that interest rates as high as 30% may occur for such unsecured debts, which effectively reduces the amount of money available for “demand” by one-third. While it may be beneficial to the finance companies, such a cost will decimate an economy since there are neither goods nor services provided by an interest rate.

    In general when credit repayment extends out over several years, there is a permanent loss of revenue to the economy for goods and services. In effect the spending was compressed into a smaller window, which results in stagnation until equilibrium (funds become available) returns. In the same way, it doesn’t do a company any good to sell its products for six months and then have six months off, if that isn’t how their production schedule is setup. This will result in lay-offs and other effects which, once again, reduce the “demand” side of the equation.

    There is a myth in some of the economic concepts that the excess revenue will be invested back into business and thereby stimulate continued economic growth. This is patently false, since supply-side production is not a cash-flow problem. There has never been a single job created solely based on the availability of excess cash. It is a problem that can only be cured by demand for products. Therefore, there must be product demand which will stimulate the supply which will garner investments. Supply does not create demand.

    In effect, the economy depends on a continuous flow of money through the system and not simply sporadic spurts of activity. Anything that disrupts that flow will disrupt the economy. While the economy will certainly stabilize given enough time, the chaos of the intervening time period is an unnecessary aberration caused by attempts to over-stimulate the growth of “demand” by the use of virtual money; credit.

    Comments

    kerrjac
    Supply does not create demand.
    For an imperfect but popular refutation of this, see Say's Law (often misinterpreted as meaning that supply of product x causes demand for product x).

    It makes little difference about the initial benefit of acquiring the good and services early, because over time, the effect is diluted by the long-term costs of servicing the debt.

    You're right that government-backed or -pressured expansions of credit won't do much good. It doesn't matter whether government is pushing banks to loan out TARP funds during a recession, or lowering mortgage standards during a boom.

    At the same time, credit - even in the form of unsecured debt - is a core aspect of the economy, not just a temporal side-effect. It is not simply a question of subtracting the initial loan from the total amount paid back over time. Because in between loan&repayment, value ostensibly is created. Say you're referring to an individual consumer taking a loan out on a car; it's not hard to see how the value gained from having a car (in return for paying more over the long run) can exceed the interest on the loan, perhaps by: avoiding more expensive transportation, being more open to other opportunities thru travel, accepting jobs that require a car, etc. This becomes more obvious when a business takes out a loan.

    In effect, the economy depends on a continuous flow of money through the system and not simply sporadic spurts of activity.

    It's important to keep in mind that generating money is not the purpose of an economy. If it were, then we could just print bills (or even more creative, print bills with a short expiration date on them). Something qualitative is added in this process, and usually this something is originally funded by some form of credit. But like you say, that doesn't mean that artifically increasing credit does you any good.
    Gerhard Adam
    ... is a core aspect of the economy, not just a temporal side-effect
    Actually it's not.  It's been only during my lifetime alone, that I've seen concepts like credit cards go from questionable novel ideas to a necessity to dozens residing in an individual's wallet.  This is a radical and marked departure from normal economics.  Bear in mind that I was talking about unsecured debt (not cars, etc.).
    It doesn't matter whether government is pushing banks to loan out TARP funds during a recession, or lowering mortgage standards during a boom.
    This isn't about government.  It's about financial institutions lending money to people to stimulate an artificial growth based on the assumption that the bill would come due at some point in the future.  Well, now it's the future.

    Just like a business that grows too fast is likely to become over-extended and have a higher probability of failure, an economy can't grow faster than it's ability to maintain the flow of money.  Too much credit has the effect of growing too fast, which creates large boom and bust cycles that are simply detrimental and unnecessary.
    It's important to keep in mind that generating money is not the purpose of an economy.
    I agree, it's to maintain a flow of money and hopefully to sustain growth along the way.  The past decade and a half have seen insanity on the growth fronts and when it collapses everyone shakes their heads and wonders how anyone could have been so foolish.  Such growth has accelerating prices far beyond values, and has now created a situation where too many people are "upside down" in owing more money than any of their assets are worth.  We have managed to create a society that we can no longer afford to maintain or potentially even live in.
    Mundus vult decipi
    kerrjac
    The past decade and a half have seen insanity on the growth fronts and
    when it collapses everyone shakes their heads and wonders how anyone
    could have been so foolish.
    It's not about monetary growth, but qualitative growth. The past decade and half have seen the rise of the computer, internet, a vast acceleration of the speed of information, not to mention its share of medical&scientific breakthroughs, particularly in GMO's. Imagine that over 20 years ago, few offices had PCs. They did everything by hand. Money comes&goes, but these qualitative types of progress are permanent. Even if we become so broke that we can't afford to power any of this technology, the gains in knowledge have been unparalleled, & the knowledge will always be there to be utilized in the future.

    These advances have come part & parcel with economic improvements, both in terms of funding them & demanding them.

    Too much credit has the effect of growing too fast, which creates large
    boom and bust cycles that are simply detrimental and unnecessary.
    The determination, however, of what exactly is too much is highly variable over time & across countries. For instance, developing nations tend to have higher savings, but they also have higher growth, particularly b/c they have higher margins. If you strong-armed American consumers into having better savings, then it wouldn't necessarily translate into better growth. But on the other hand, real growth might convince Americans to save more thru higher interest rates. But between inflation (soon to worsen) and low interest rates (both mostly influenced by gov't), it makes less sense to save; as the real interest rate (determined by official interest rate & inflation) becomes negative, it theoretically doesn't make sense to save. Regardless, it's dangerous to let the government choose these things, but that's not to say that all credit is bad.

    It's been only during my lifetime alone, that I've seen concepts like
    credit cards go from questionable novel ideas to a necessity to dozens
    residing in an individual's wallet.
    Consider as well corresponding rises of other things that make a credit card more useful: convenient consumer goods (no use for the card in a desert); online business; spread of technology (that is, to swipe the thing); the inconvenience of carrying around money (which increases with purchasing power); not to mention the rise as well in the debit card.
    Gerhard Adam

    They did everything by hand. Money comes&goes, but these qualitative types of progress are permanent.
    That's not necessarily an improvement.  People waste inordinate amounts of time having to reply to e-mails every day that are trivial and simply burn up hours.  There is no question that there are benefits to many of the technological developments you've mentioned, but there is nothing to suggest that such benefits wouldn't have been obtained with a more reasonable growth model either.

    This isn't about stopping development, but rather it's about putting away the rose-colored glasses and stop being so starry eyed about every new "pet rock" innovation.

    As I said before, I'm not opposed to all credit, but rather the ruinous interest rates, and long-term debt that conveys no value. 

    Similarly, I'm put off by all the experts that spent years talking about how government deficits weren't necessarily a bad thing and then chastising consumers for their deficit spending practices.  The truth is that debt is never a good thing when it becomes long-term.  This causes us to waste national (and personal) resources for no purpose except fulfilling the interest obligations on that debt and having to make more and more frugal decisions just to keep our heads above water. 

    I've even heard economists talk about how our GDP is so large that the debt is trivial by comparison.  What what kind of stupid comparison is that, as if we can just trade in the country should we happen to default?  The biggest problem now, is that if we don't figure this out, we will find ourselves living in a country that no longer has the ability to determine its own destiny because its financial masters will determine how that future will play out.

    Mundus vult decipi