The Definition of Credit Economics

by Catherine Capozzi; Updated September 26, 2017
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Many people understand the term “credit” by applying it to their personal finances: when they charge a purchase to their credit card, for instance, they are using borrowed money they agree to pay back with interest. This idea of credit applies to the overall economy as well. How banks and individuals operate, as regulated by the monetary system, is the basis for credit economics.

History

Though taking out a loan from a friend is nothing new, an entire country’s economy was not always based on credit as we know it today. According to the Ludwig Von Mises Institute, in the 1600s, societies bartered with commodities: Africa traded salt, American settlers traded tobacco and fish, and the Caribbean traded sugar. However, this system is inherently inefficient. In the 1800s, the U.S. government transitioned to paper money “backed” by gold. Under these early systems, money could never be printed without ensuring a valuable commodity existed for printed currency. Since the 1970s, though, the U.S. has printed money and, more critically, banks can lend money without it being backed by any commodity.

Misconceptions

When the bank loans customers money for a mortgage or a car, people often believe the bank actually has the cash on hand. However, banks are able to distribute far more money than they have in deposits. Because banks do not actually have these amounts of cash, they operate on credit as well. The Federal Reserve regulates how much money banks must have in deposits with respect to how much they can loan. This type of lending is called “fractional reserve lending.” Hence, just as a consumer can buy on credit, banks loan on credit as well.

Consequences

Lending and borrowing on credit are not without consequence to the U.S. economy. The U.S. experienced such consequences during the Great Depression when the banks collapsed due to creditors calling in their deposits. Another consequence of credit economics also occurs to the general money supply. The film, “Money as Debt,” by Paul Grignon explains that the interest charged by the banks creates money that can never be paid back. Though the principal balance is eliminated as outstanding credit from the money system upon repayment, the interest rate amount is new money that can never be destroyed. The re-lending of the money accrued from interest means someone must always re-absorb this money as debt at interest for the system to be maintained. This means the debt created from lending is always greater than the amount of money available to be earned.

Significance

Grignon argues this constant expansion of the money supply due to this form of credit economics is not sustainable. This is due to the finite resources of the planet. Basically, debt is created faster than people are capable of earning and producing. Martin Wolf explains in the book, “Fixing Global Finance,” that if a government’s credit becomes exhausted, like a person with a maxed-out credit card, the risk of default is high. The country prints more cash to pay its debt which, in turn, causes inflation.

Considerations

As with credit cards, some debt is not necessarily bad. Credit allows consumers to purchase goods and services, as well as use the money to invest in an account with potentially higher interest rates. However, too much debt means a country must repay this amount, with interest, through the form of higher taxes or reduced spending.

About the Author

Since 2008 Catherine Capozzi has been writing business, finance and economics-related articles from her home in the sunny state of Arizona. She is pursuing a Bachelor of Science in economics from the W.P. Carey School of Business at Arizona State University, which has given her a love of spreadsheets and corporate life.

Photo Credits

  • wallet cash and credit card image by Warren Millar from Fotolia.com