Abacus: Credit and Its Role in Economics
Busakorn Pongparnit
The word “credit” is often used in conversations associated with money and personal finance. The term is typically used to refer to credit cards, instruments used by millions of people every day in large countries, helping process trillions of dollars’ worth of transactions each year. Some people, including trained financial advisors, hold a pessimistic view of credit cards, perceiving them as pieces of plastic that burden users in the long-term, only to drive profits higher for banks. Others, including many advisors, discern such cards as a useful tool that can be used to build and maintain a high credit score, which in turn could lead to a better chance of attaining necessary loans at low interest rates.
In reality, credit plays a huge role in the functionality of financial markets and the broader economy. While risks and downsides certainly exist for banks and other institutions that issue lines of credit to individuals and businesses, the ability to gain the trust of a lender and, in turn, acquire goods and services before making any explicit payments has historically served as a great boost to economic activity.
The action of waiting to pay in full for products in the United States did not become popular until the early 20th century, when the businessman Henry Ford introduced the first model of the Ford automobile, the Model T. When the model was launched in 1908, the lowest price that consumers could purchase it for was $825 (a value equal to approximately $23,235 in 2020). While comparably inexpensive for an automobile at the time, many citizens were unable to afford to pay the full price of the car at once.
To help consumers afford desired cars, the vehicle manufacturer General Motors created General Motors Acceptance Corporation (now Ally Financial) in order to help automobile-seekers finance their car payments over periods of time. The invention of newer car models and other consumer goods, as well as financial programs that helped middle-class workers afford highly regarded products, contributed to a rapid rise in consumption and economic gains: statistics compiled by the California State University, Northridge show that, after adjusting for inflation, Gross Domestic Product increased by more than 42% during the 1920’s.
Moreover, the stock market flourished during the period, as consumers and investors became increasingly confident that newly created inventions and merchandise, as well as an economy largely dependent on credit, would allow for business to thrive: from the start of 1921 through the beginning of 1928, the S&P 500 realized an average annual gain of 23.49%.
As significant as being granted easy access to payment plans was for middle-class workers desiring lavish products, the relatively unchallenged access to luxury goods was partially responsible for the eventual downfall of the US economy, known infamously as the Great Depression. To elaborate, one of the reasons why the stock market enjoyed great gains during the 1920’s was due to speculation on the part of ordinary Americans: many people hoped to acquire a piece of the wealth so many others seemed to gain during the decade, with many buying stocks on margin, implying that they went into to debt to afford immediate stock purchases.
For a market built primarily on the consumption of cars, homes, and other appliances, investors recognized that the share prices of many corporations were overpriced, and took advantage of overvaluations by selling stocks for a profit. The accelerated selling that was inflated by speculation, in addition to a surplus of farm goods chiefly brought about by worker movement from the Midwest to industrial cities, thus hurting farmers and other agriculture workers, helped contribute to a steep market crash and economic downturn: not more than three years after the S&P 500 reached a record high in September 1929, it had lost more than 86% of its value, an unprecedented decline.
Although the United States has not experienced anything quite like the 1920’s economy, one that was built on credit purchases and overconfidence to such a great extent, the effect of credit still plays a significant role in economic and financial decision-making in other ways, especially in exchanges that rely on credit-worthiness.
Corporations and other firms in need of funds to finance their ventures tend to turn to the bond market for help. The bond market, known otherwise as a market for debt, allows for government agencies and certain financial institutions, like pension funds and mutual funds, to issue debt in the form of bonds and other securities. Exchanges in the bond market allow for sellers of bonds to obtain desired capital, while buyers of such securities can earn a return from the charged interest rate.
As COVID-19 started to spread across the United States before a pandemic was officially declared, participants in the bond market became concerned about how the virus could potentially affect business activity on the national level. Starting in late February, the difference between the rate of interest on a given bond issued by a particular corporation and the rate of interest charged for a specific type of bond (typically a government-backed bond, like a Treasury bond), increased dramatically. This difference, known as the yield spread, signified that corporations of all types, from those that are typically trustworthy in paying back debt, to those which are less reliable, were at greater than average risk of not paying back debts due to the possibility of businesses shutting down. Indeed, the credit spread for some corporations rose by more than 100% in less than a month, with much of this spike being a result of companies yielding higher interest rates as a form of compensation for greater perceived risk on the part of borrowers.
It wasn’t until the Federal Reserve announced measures that it would take, including providing nearly $300 billion in the form of credit to employers, consumers, and businesses, when financial market players started to become more content with the changed economy, and credit spreads began to drop.
Akin to how credit operates on a macro-level, individual humans can use credit for their own personal gains and losses. With many young people curious about whether they should be using a credit card, and as financial gurus espouse mixed messages on matters pertaining to the concern, it can be understandably troublesome to determine whether one should bother applying for a card at all.
By and large, if a credit card is used responsibly over a sustained period of time, it can serve as a tremendous tool to strengthen one’s credit history and credit score. A long history of making full payments for all financial obligations on time can serve as a sign to banks that a given individual is financially responsible, and that he or she has the necessary resources to pay back debts. A high credit score (typically considered to be 700 or higher based on FICO ratings), can not only lead to someone having a better to chance to receive loans to accomplish personal goals, like buying a house or continuing their education, but also being granted lower interest rates on such loans.
On the other hand, people who are more prone to spend large amounts of money that they do not have should stay away from credit cards, as the inability to fully pay monthly payments in a timely manner can not only be damaging to one’s credit score, but also to one’s savings: the average interest rate on commercial bank credit card accounts in May was 14.52%, an exceedingly higher percentage than rates on other types of debt and loans, like mortgages.
For people who face problems with high spending, it could be best to conduct transactions with only cash for a certain period of time, as doing so gives one a more accurate understanding of the amount of money they could reasonably afford to spend on any given day.
Those who deem themselves financially accountable and, furthermore, have either a stable job or sufficient money in savings, should consider applying for a credit card. How one chooses to use a credit card is parallel to how credit operates comprehensively in the economy: if used sensibly, it could grant a user with the standard of living they are accustomed to, as well as supplement them with greater opportunities in the future. Used without regards to consequences, and credit could be detrimental to one’s financial foundation.
