First, as background, a few words on credit and its uses.
For the most part, it’s employed in one of four ways: the provision of working capital, funding new investment, the purchase of existing assets, or consumption.
The first two are inherently constructive (not that all investments prove to be productive, of course, but at least that’s the goal). The effect of the other two is decidedly less clearcut.
If credit finds its way to entrepreneurs or managers who make better use of the assets it enables them to purchase, society undoubtedly benefits. If, on the other hand, widespread asset-based lending takes hold, the effects are invariably negative, sometimes disastrously so.
Lending for consumption can also certainly make economic sense; acquiring durable goods on credit, for example, or purchasing a home (which ought also, at least in part, be considered as consumption).
It’s all too easy, though, for consumption credit to become toxic, not only for individual borrowers but also for society at large, particularly when dressed up as asset-based lending. Credit induced booms in asset prices create the illusion of increasing wealth and entice households into cutting back on savings and borrowing, often well beyond their means. For so long as the illusion lasts, it’s self reinforcing; increased economic activity appears to justify the rising asset prices and vice versa.
However, since consumption based on credit is ‘borrowed’ from the future, when it persists for long enough many businesses will be misled into investing in productive capacity well beyond the sustainable level of income-based consumption. Nor are they alone; in such heady boom conditions, many households are also seduced into overextending themselves, whether it be in real estate, shares or some more exotic speculation.
The result of all this is an unhappy combination of chronic imbalances. When the music finally stops, households have little choice but to batten down and save for an extended period, while businesses have to either write off, or find alternative uses for, all those malinvestments. Similar imbalances often occur at a national level.
All of which is, of course, pretty much exactly what happened in the lead up to the recent crisis.
Credit, then, is a decidedly mixed blessing.