Sunday, December 16, 2012

The Nature of Credit (II)

Credit is an amazing economic instrument.

Credit is the primary vehicle through which we communicate and translate economic values across times. An individual who has an excess of resources today can use them to either pay back expenses made in the past or to support other businesses who will pay them back in the future. Time can be traded just like any other goods or services.This is astounding.

It is astounding because, given credit and perfect rationality, the amount of economic activity at any given time should be always focused on the present. When this does not happen we have an economic crisis, be it depression, recession, or inflation.

So, if today I know that I have an excess of resources I should be able to pretty easily pay back past obligations and sustain the excess of resources for the future, via credit. My natural inclination would be to be in a perfect balance today as I know that, if current conditions persist, I can sustain the balance going forward.

If I make $1,000 this week and need to pay for my past loans $200 and save for future growth $200 then the $600 left over should be sufficient for living. If I save even more than $200 then I will have even less resources today but this implies that I am optimistic about the future.

Bring the government into this equation and we will see how they take away any and all incentives to save for the future while trying to decrease the value of my past loan obligations.

Now, -if I have the same job- I still make $1,000 this week and government (via the central bank) decides that the value of credit should be less than it used to be (using quantitative easing, for instance).

So, I used to owe $200 for past loans and now they are worth $150 while the value of saving for the future also decreases by $50. So, I have $700 left to spend. What should I do with the extra $100? Well, if cost of living went up and state and local taxes went up I may end up with nothing more than I used to have before. All the federal government did was to make private businesses and sate/local governments charge more for the same goods and services. The net effect is 0 (at the very best). There are other cases where the net effect of the government actions is at most 0 and very few where the effects are greater than 0.

We are slaves to the central bank's actions and they have a very thin hit zone of success.

Another outcome to consider is listed below.

If I do not pay my $200 loan at all this will enable me to have more resources today but this also signals that the degree of risk in the economy is not well quantified. Higher risks imply higher returns and higher values of the credit costs. Contrary to expectations and economic theory, this has not happened at all. If I save more then I am not rational as the interest rates are too low.

So, I can either invest the money or spend it all.

The central bank is practically forcing us to take actions against or best individual interests. Think about it for a second. A government body not elected by us is telling us what is best for us... At least economically. If there are no economic freedoms then we have no other kinds of freedoms.

Credit is an amazing instrument until the government dilutes its value to almost nothing.


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