Understanding the concepts of credit, debt, and growth is crucial to grasping how modern economies function. That in turn gives you the bigger picture context you need to manage your finances. Although this post focuses on the US financial system, these concepts apply to all modern global financial systems.
Let’s start with this video (first 22 mins) from Mike Maloney’s “Hidden Secrets of Money” series. By the time you finish it, you will better understand how the financial system creates credit. Note that Mike has a specific point of view about the financial system and the role played by the Federal Reserve. You can easily separate the facts from opinion and form your own views.
Credit: The Extension of Resources
Credit means one party trusts another party to supply resources and expects future repayment. The repayment includes an interest, which is the return the lender earns for allowing their resources to be used by the borrower.
In the financial world, this often takes the form of loans, credit cards, or lines of credit. Mike’s video clearly explains how fractional reserve lending creates an ever-increasing amount of currency as banks lend funds to borrowers. Given this leverage, heavy regulation applies to banks.
Other types of lenders, such as hedge funds and private finance companies such as Business Development Corporations, can pool capital and lend those funds out. However, they do not enjoy the privilege of fractional reserve lending.
Leasing companies are another category of credit providers. Instead of lending funds, they lease vehicles or equipment like airplanes or heavy machinery to businesses or individuals. This allows the lessees (those who lease) to use capital-intensive equipment without buying it outright.
Debt: The Obligation to Repay
Debt occurs when you borrow funds or other resources. That part is straightforward and needs no further explanation. But why does the concept of debt exist at all? What happens if there is no such notion in our world?
Imagine a World Without Credit
John and Jane are a young couple just starting out in their careers. They have a decent combined income, enough to pay for their living expenses and save a wee bit. As their family needs grew, they decided to buy a home rather than move to a larger rented apartment. But they do not have enough savings to pay for a house. In a world with no notion of debt, their only choice is to save until they have enough to buy a house outright. Maybe, in twenty years. Or forty?
Farmer Raju owns a medium-sized farm and has been growing cotton all his life. As cheap synthetic textiles proliferated, his income started to go down. He consulted with a farming expert and decided to switch to organic farming. It would take a couple of years to switch, but that would leave him in a better position. But he needs capital to make that transition. In a world with no notion of debt, Raju’s only choice is to make a terribly slow transition. Maybe he will make that transition in the long term. Maybe not. He can smell the opportunity, but he does not have enough capital to make that investment.
Acme Steel produces steel. It is an extremely competitive, capital-intensive, low-margin business. One of its engineers created an innovative process to produce better quality steel much more efficiently. The owner can see profits racking up after upgrading the factory to adopt the new process. But she does not have enough capital to idle the factory, replace the equipment, and retrain her employees to employ the new process. In a world with no notion of debt, Acme Steel’s options are either to sell the innovation to someone with capital or wait a few years to accumulate sufficient capital.
Debt Powers Growth
We imagined a world without debt and saw the difficulties inherent in such a world. Now let’s come back to reality, to the world where we have had the notion of debt as far as we can remember.
John and Jane, the young couple from the example above, can borrow enough funds from the bank to buy a starter home. By doing so, their borrowing has effectively funded the construction of a new home along with all the furniture and appliances that go with it. That’s a small contribution to the growth of the economy funded by debt.
Similarly, Farmer Raju and Acme Steel were able to convince a bank to lend them sufficient capital to power their growth. As a result, they both bought new equipment, hired new employees, and/or taught new skills to their existing employees. As a result, their borrowing contributed to the growth in the economy.
Debt allows the borrower to do something today that they otherwise would have had to wait a long time. Or perhaps, never!
Successful Growth Pays Off Debt
If all goes according to plan, all the borrowers in our example will eventually pay off their debt using their future higher income. However, let’s say one of them was unable to grow their income enough to pay off the debt. They are still on the hook for the debt, so the lender will likely sell off whatever the borrower mortgaged to secure the loan to recoup all or part of the loan.
In a large enough economy, there will be a small number of failures even under the best of circumstances. But since most borrowers were able to pay off their debts thanks to higher incomes, the net result is growth in the economy.
Sometimes, as happened during the Great Financial Crisis of 2008, the number of borrowers who can’t pay off (service) their debt can climb rapidly. The debt still exists. For each borrower who borrowed a dollar, there is a lender who lent that dollar. The borrower didn’t experience the growth in income they expected to have. If the lender couldn’t recover the remaining loan, they in turn will be unable to experience the growth in income they expected to have. Net result: unrealized growth, which resulted in unpaid debt, leads to lower overall growth.
In summary, economic growth plays a critical role in managing debt. As economies grow, they produce more goods, services, and overall wealth. This growth helps manage and absorb the credit (debt) created in the economy.
Another Way to Finance Growth
You now understand how credit (debt) helps juice economic growth. A loan has well-understood terms. The lender knows exactly what they will get when the loan is paid off. The borrower is on the hook until they repay the debt. Let’s revisit Acme Steel, the company with an innovative process that it expects will power its growth. The owner is aware that despite her best efforts, there’s a small chance that something could go wrong and result in financial ruin for her company. Any capital they borrow must be repaid under any circumstance. Is there any way she can raise the needed capital such that the risk spreads across multiple owners?
Yes, there is an alternative to debt. She can sell part (equity) of Acme Steel to others, resulting in multiple owners (shareholders). The capital realized from this sale can now fund the upgrade. As shareholders, they assume the risk of the innovation not working out as planned. Hopefully, it works out better than expected and they enjoy a good return on their investment. Risk and reward. If it turns out that they miscalculated the amount of capital they needed to implement the innovation, they have the option once more to either borrow or sell more shares to raise new capital.
The Two Ways to Finance Growth
To summarize, there are only two distinct ways someone can finance expected growth. One involves borrowing funds (debt financing) and the other involves selling partial ownership, aka equity (equity financing). Given the wide range of borrowers, investors, companies, and circumstances, it’s not surprising that several products such as convertible bonds and preferred stock combine features of debt and equity to meet specific needs. These are beyond the scope of this post. Nevertheless, the big takeaway is debt financing and equity financing are the two distinct ways to finance growth.
How’s it Relevant to You?
As we discussed in currency and money, your savings should keep up with inflation. Lending your savings to a bank or the government can earn you a well-defined, low-risk return. Or, you can accept higher risk by lending to corporations or even foreign governments. This is known as fixed income investing.
You can accept even higher risk and buy ownership in publicly traded companies. You could even buy ownership in privately held companies, though that requires a much higher risk and higher level of due diligence. This is known as growth investing.
Much has been written about the “ideal” split of savings between fixed income and stocks. It’s about figuring out how much risk to assume. Historically, in the United States, stocks have performed better than bonds (fixed income). Higher the risk, higher the reward. But risk does raise its ugly head on occasion and stocks have underperformed bonds for significant periods of time during bear markets. Spend some time at this site and digest the long-term trends and relative performance over at least 100 years.
One parting thought. Be purposeful with any debt you incur. Don’t find yourself in a situation where you are working hard today to pay for fun you had in the past.
Subscribe to receive updates in your email: