Understanding “economy” takes years and years of study. And, because it is considered a social science, no one can truly and fully understand all there is to know about the economy. After all, global trade wars are never supposed to end well for the global economy, but yet somehow they still happen…
For me, I’ve been studying economy and finance for less than a year. Still, I’ve had many “holy sub-prime mortgage bonds!” moments. And, in those moments, I feel as if I just came across some sort of an economic enlightenment about how the world works. So, in the spirit of sharing this economic enlightenment, I’ve decided to write about cool economic concepts I come across either through books, videos, podcasts, or in class.
This post is about credit and spending.
Credit and Spending is the backbone of the economy.
What is credit? When you use a credit card, you are spending money you don’t technically have, but agree to pay later on. When you receive a loan from someone, you are receiving credit in exchange for a promise to pay it back (with interest), or collateral (you can take my house if I default). In a way, you are literally fabricating money from thin air.
Credit is facilitated by banks. Citizens (me and you) deposit money that we “own” into a bank account, and the bank—as a middleman—can use our money and lend it out to other people as credit, such as an entrepreneur, business, or family, who will (hopefully) be productive with that money, such as start a company, grow the business, or finance a home. Yes. Banks loan out money they don’t own. Let that sink in a little bit. Still, it’s a very crucial part of our economy, because banks facilitate credit.
When people receive credit from the bank and spend their money in a productive way, (creating more money), they are adding to the economic output of the country. Because one person’s spending is another person’s income, the more I spend, the more money will be exchanged from my hand to another person’s hand, who now has more money to spend themselves, and thus the cycle continues. The important thing to understand is that credit and spending (generally) have a positive correlation.
Because one person’s spending is another person’s income (I spend $100 at a local business, that business now has +$100 in income), the more I spend, the more income someone else has, and thus, the more credit they can receive (to keep it simple, let’s say everyone can receive 10% of their income as extra credit from the bank, and everyone exercises their ability to receive and spend all of their available credit).
So here is the cycle. I spend $100. Person X now has $100 income + $10 credit. He spends all $110 at person Y’s business. Person Y has $110 income + $11 credit. Person Y spends $121 at person Z’s business. Person Z spends $121 income + $12.1 credit.
Seems all good and dandy, right? The economy is bustling, people are spending and creating goods and services. But as the cycle continues, people’s income increases, but so does future debt and the accumulated interest on the borrowed credit. The problem is that an economy run on credit-heavy financing can flourish in the short-term, but will eventually reverse and potentially collapse when the debt burden becomes too great and people begin defaulting on their credit (unable to pay back the money they borrow). This, in very trite terms, is what happened in the 2008 financial crisis, and is essentially a major cause of most financial recessions. What goes up, must come back down. That’s the economic cycle, and it happens not just on an individual person basis but on a mass-scale countrywide basis.
Spending and credit are good for stimulating the economy, but too much debt and credit leads to recession and phases where citizens need to save more money and spend less. Remember, if you spend money you don’t have right now (credit), you are essentially borrowing money from your future self. If your future self is not richer than your current self, then you’ve essentially robbed your own future.
America has a spending problem, the economy is booming but so is debt and credit, while several Asian countries have almost a weird savings problem (China, Japan, Singapore). When both spending and credit are high, and the economy is being stimulated by growth, the music will be playing for the economy. However, when the music stops, things get quite awkward, and fast. The key is to find the right tempo: a balance of credit & spending with savings.
- Spending & credit drives the economy because: One person’s spending is another person’s income, higher income equals more creditworthy, more credit equals more money and more spending, more spending equals higher income.
- Credit and debt are not always bad and is best used in a productive way (ie: business/entrepreneurship, investments, or other ways of creating more money). Credit spent on items that immediately depreciate in value is bad. (ie: new clothes, new car, new watch)
- If mass amounts of people suddenly default on their credit (unable to pay back), while on the same hand the people who are loaning the credit (people who have money at the bank) want their money back but can’t receive it from the people who defaulted, we get something similar to the 2008 recession.