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.
Economic Theory - The Role of Credit