Lasting Situations of Wealth

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; i.e., 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 oppor-tunities. 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 its 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 Freddie 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.

No Assets, No Credit?

For a long time, the way to climb the financial ladder was to accumulate wealth incrementally through diligence and thrift. People scrimped, saved, laid a financial foundation, and built their fortune over time. They left their heirs with assets to continue the process.

In the past half-century, the incremental, multi-generational method of wealth-building has been supplanted by a leveraged approach. Calculated borrowing (for a better education, for a home in an up-scale neighborhood, for a business opportunity, etc.) made it possible to acquire things today, pay for them tomorrow, and end up with substantial accumulated wealth as well (because the home appreciated in value, the college education brought a lifetime of higher income, and the business was sold to someone else). The leveraged approach makes it easier for more people to have more of the “good life” sooner, as long two conditions are present: first, borrowers faithfully make monthly payments for their mortgage, auto loans, and credit cards; second, the underlying assets continue to appreciate.

Many Americans and many American businesses, have taken the leveraged approach. Some borrowed because they had no other options. Others reasoned that rising income and future profitability would let them use credit as a financial shortcut. Today, they find themselves with limited savings, too much debt, and only one way to keep afloat: by deferring payments until a later date. The President is correct in stating that many Americans are dependent on lenders for their economic survival.

But a revived credit economy will happen only if lenders believe their loans will be repaid. And there is the rub. Right now, lenders don’t think the average American, or his/her business, is a good risk. The economy is in the tank, real estate values have plummeted, unemployment is up. Legislators can regulate lending practices and give institutions more money, but they can’t force lenders to make risky loans.

Right now, lenders have a particular aversion to borrowers without assets. For those with assets (positive cash flow, savings, equity, etc.) credit is available, often on better terms than before the recession. But for those without assets, credit is either expensive or unavailable.

This separation of credit haves and have-nots based on accumulated assets was highlighted in the headline article from the August 29-30, 2009 Wall Street Journal, titled “Halting Recovery Divides America in Two.” On one end, the CEO of a national restaurant chain with $100 million in cash and no debt says, “For us, this is the best of times. Cash is king and this is a buyer’s market.” At the other end a high-tech irrigation company can’t get financing to fill large orders because “these are the bumps in the road that are driven by being cash-poor.”

At some point, individuals have to come to grips with these realities. Notwithstanding the big-picture perspectives of economists and policy-makers, the only intelligent response to the contraction of credit is to accumulate assets – to save. Otherwise, you run the risk of becoming a lifelong debt slave, with no guarantees that more credit will be available in the future. In the long run, credit-dependent individuals and businesses will be left behind.

Chris Isidore may think that a groundswell of saving and debt reduction will “only make matters worse.” There are those who beg to differ. Steven Horwitz, an economics professor at St. Lawrence offers the following rebuttal in the September 2009 issue of The Freeman:

Most saving takes the form of financial instruments, including everything from basic checking accounts to the fanciest investment tools. If people are keeping higher checking account balances or putting more in savings accounts or money market balances, that wealth is not withdrawn from the economy. It is simply channelled elsewhere than into consumer goods.

An increase in the savings rate represents a change in consumers’ time preferences: They are saying; they are less interested in current consumption and more interested in future consumption… Restricting consumption does not
hamper economic growth. In the long run, economic growth requires savings and the creation of new capital goods.

Credit-fueled economies usually overheat, then flame out after many people have been burned. And the boom-bust cycle of credit always punishes greed and impatience.

The key action for financial recovery is saving. Even in this recession, there are still financial instruments that can serve as safe and productive repositories for your dollars. Find these instruments, and use them.

There are still legitimate, wealth-building reasons to borrow, but borrowers strike the best credit agreements when they can bring assets to the table. Even better, savers may eventually become lenders. If borrowers are debt slaves, then lenders are the masters. Plato is right: to refuse to master your finances puts you at risk of being mastered by others – and not liking it. Saving is the essential action that makes it possible for you to control your financial destiny.

• WHERE DO YOU STAND ON THE DEBT DIVIDE? ARE YOU A BORROWER WITHOUT ASSETS?
• WHO CONTROLS YOUR FINANCIAL DESTINY?
• THERE ARE STILL GOOD PLACES TO SAVE!