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Most of us have a basic understanding of how credit works based on our personal experiences. We borrow someone else’s money (the bank’s, the mortgage company’s, a friend’s) to buy something today, and then repay the lender with interest. That’s the basic formula whether credit is used to buy a house, a car, or dinner at a restaurant.
Likewise, our decision to take on a debt obligation is usually as simple as “who will lend me the money?” and “can I afford the payments?” Our assessment of our use of credit is often measured by our payment history and credit score. (i.e., “I have a credit score of 810, so I guess that shows I know how to borrow effectively.”).
But lenders and economic policymakers have bigger agendas and different objectives. Here’s how credit impacts the broader economy.
Credit is Like Lighter Fluid on Charcoal; It Gets Things Started Faster
Instead of having to save for long time in order to obtain a big-ticket item (like a house or an automobile), credit allows the borrower to have the item immediately, while using future earnings to make repayments over a period of time.
Credit Expands Purchasing Power; IE: It Allows People to Buy More Things
And the more people buy, the more the economy expands.
In the short term, everyone likes the effects of credit. Buyers get what they want today, sales rise for businesses, and lenders add to their income streams by collecting more payments.
Of course, there are consequences to speeding up commerce and expanding purchasing power.
Borrowers May Forfeit Future Financial Opportunities
Using credit today predetermines how a portion of tomorrow’s earnings will be spent, because borrowers are committed to making payments at a later date. Who knows what future opportunities will be forgone because of an outstanding loan obligation?
Abundant Credit Usually Results In Price Increases
Wherever credit is used to purchase goods or services, the costs for those goods and services will usually increase as well, because when more people are potential buyers, the increased demand will result in higher prices.
The Credit Format Works Only as Long as Borrowers Make Payments
Having a few borrowers default is inevitable, but too many defaults make lending unworkable for both borrowers and lenders. If borrowers can’t afford the interest rates and lenders can’t afford to lend money, it won’t be repaid. When the flow of credit slows or stops, the economic activity dependent on credit often contracts as well. This is why credit-driven economies have regular cycles of expansion and contraction.
Because of it’s Lighter-Fluid-Like Impact, Politicians Often Enact Legislation to Facilitate Credit in Favored Segments of the Economy
For example:
- Government-approved student loans feature deferred payments and lower interest rates (because they are subsidized/supported by tax dollars) to encourage borrowing for higher education.
- FHA, Fannie Mae, Freddie Mac and other special programs for low-income and first-time home buyers provide additional incentives for both borrowers and lenders to enter into mortgages.
- The “cash-for-clunkers” rebates provoked a brief burst of automobile purchases, the majority of which were financed.
The perceived societal benefits of college education and home ownership may provide a rationale for making it easier for people to borrow. But a frequent unintended side effect of special borrowing programs is greater price distortion in those areas. In an August 24, 2009 Atlantic article, Niraj Chokshi writes that Labor Department statistics show “for 27 of the past 30 years, the price of education has grown at a faster rate than that of medical care. Education also grew faster than inflation for 29 of the past 30 years.” Likewise, many financial commentators have stated that government programs which encouraged sub-prime lending bear some responsibility for the bubble in the housing market.
Credit May Encourage Reckless or Undesirable Behavior
Distorted prices and bad credit decisions by both lenders and borrowers can’t be blamed on government policy alone. Many people simply can’t handle debt responsibly – they borrow too much, spend recklessly, miss payments, lose the house and go broke. Some lenders prey on the weakness of borrowers. They charge exorbitant interest rates and fees, or keep offering credit cards to those who are already over their head. The flaws in human nature make any credit agreement a potentially dicey proposition. Here’s financial analyst Ian Hodge’s explanation from an April 26, 2009 blog commentary:
…you can see that the real problem is instant gratification. People don’t like to wait for something in the future. They want it now.
Because their appetite is insatiable, the demand for instant gratification drives sellers in the marketplace to constantly increase their prices, and they don’t care that ordinary folk have to go into debt to buy their goods. In fact, they have a vested interest in debt, because now they can get higher prices for their goods. This is especially true in the real estate market. This is why I have never heard any property developer complain about the high debt levels in the economy.
No home seller complained about Fannie Mae and Freddie Mac. They were happy to leave the problem to “other” people. They took their inflated prices and pocketed the huge increases in property values that were driven by debt.
Instant gratification. Sellers were not prepared to wait for higher prices that might come through supply and demand. Instead, they preferred the instant higher prices obtainable through debt.
Thus it is the greed of sellers – coupled with the… buyers who want to borrow – that is the cause of our economic problem.
Borrowing and lending has the potential to be a corrupting agent – financially and ethically. While most discussions today regarding credit focus only on financial particulars, there are important social and moral implications to the use of credit as well. Historically, many societies banned or stigmatized lending because of the potential for abuses. This particularly applied to lending to individuals (as opposed to business organizations or governments). Because credit is like lighter fluid, it can burn things up as well as get them started.
