Credit is defined as the trust or reliance which allows one party to entrust their money with another source with the knowledge that they will receive it back within a stipulated period of time. The entire global financial world is built upon this very concept of trust. The trust that allows a man to loan money to his neighbour, that allows a bank to invest in growth projects, that encourages investors to pool funds into certain ventures. They all expect their money back within a period of time with some returns of course. Thus it is credit which has led to the formation of numerous financial instruments and has ultimately shaped the global financial markets today. However, the disadvantages of credit are manifold as well.
Every coin has two sides and true to this universal concept, the spread of credit too has led to its own share of disadvantages. These disadvantages of credit are often overlooked. There is credit floating around everywhere around us, whether it is the incessant sales calls from banks asking us to apply for their new credit card schemes, or the uncountable financial instruments (stocks, bonds, debentures etc) being advertised as vociferously as possible. Every time we use the phone, the electricity in our homes or buy a house on a loan, we are using credit. There are some serious disadvantages of credit when observed carefully. If the situation is looked at from a different perspective, it becomes a subject of curiosity as to why creditors would pursue people so relentlessly to offer credit to them. Here are a few facts that come to light when a credit card, which is the most obvious and basic form of credit around individuals, is looked at from the creditor’s point of view.
Hidden Costs of Credit
The credit card companies have a lot to gain from offering people credit. They charge a handsome transaction fees from both parties involved in a credit card transaction, i.e. the payer and the receiver, making the whole deal more profitable for them. There are other hidden costs like the fines that are added directly to the credit card bill in case of late payment of dues. This makes the whole process of buying and selling more expensive for the actual parties involved, with the credit card companies emerging most profitable.
The easy availability of credit at the micro level, to a vast multitude of individuals feeds the temptation to overspend which is a noteworthy disadvantage of credit. The basic concept of credit encourages people who do not have sufficient funds currently to spend, then recovers the initial credit amount plus a holding fee at a later date. As Benjamin Franklin observed – “Creditors have better memories than debtors”. This very sentiment lies behind the actuality of dangerous recovery scams.
Credit reduces the availability of funds for use in the future. It is taken with the intention of paying the money back in the future making it a liability for the person taking it. It encourages people who might not have sufficient funds or the ability to repay the credit taken, to overdraw their accounts. This is the cause for the huge credit card default rates. This default on repayment creates problems for the creditors and others dependent on them. The cursory checks carried out by credit card companies keen to sell their product are not sufficient to determine the credit worthiness of individuals. When such default rates rise to dangerous levels, they become the breeding ground for the next business cycle dip.
The ease with which credit is made available to un-creditworthy individuals has been the basis for the biggest financial crises and recessions in the world. This is one of the disadvantages of credit that cannot be overlooked. The recent sub-prime mortgage crisis and dot-com bubble are prime examples of crises caused by loose and misaimed credit. Credit basically increases the level of debt in the world which can never be a good thing in the long run.
Credit and the Business Cycle
When credit is given on a fixed asset such as land, certain collateral is taken on the loan (credit). This is usually the asset itself for whose purchase the loan is taken, in this case, land. Thus the value of the loan, apart from depending on the repayment schedule, is also closely linked with the collateralised fixed asset, land. If a fall in land rates is expected in thefuture, the collateral against which the loan is held gets devalued. This reduces the attractiveness of providing loans for the purpose of land purchases, affecting the productivity and investment in the entire segment. Business cycles are closely linked with real asset prices.
In fact the credit cycle is considered by many, notably members of the Austrian school of thought, to be a major factor influencing variations in the world business cycles. The expansion and contraction of access to credit over the course of the business cycle defines the credit cycle. Thus when creditors/lenders focus their energies on a particular segment or industry allowing them credit at low or floating interest rates, there is an expansion in the credit cycle followed by increased productivity in the concerned industry. This leads to corresponding growth in the economy until a peak in the business cycle is reached. During this phase, asset prices rise, inducing asset price inflation.
However this exercise reaches a point where creditors do not find sufficient people to borrow money causing a price collapse. The high levels of debt in the economy cause a liquidity crisis. Large amounts of money ride on the success of these industries and an inability on their part to deliver results causes panic selling and the requirement of repayment of loans. When the default rate reaches unmanageable standards, conditions of bankruptcy are reached and foreclosures commence. The need for bailouts of the worst-affected creditors may also arise. This is a glaring example of disadvantages of credit and has been observed in the case of Lehman Brothers, a financial services firm that declared bankruptcy after the 2008 housing bubble exploded. A number of investment banks including Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and insurance giant AIG were bailed out as a part of the Emergency Economic Stabilization Act of 2008.
So, is credit good or bad?
Through these points it is clear that credit, while providing a great convenience to us and being the source of a multitude of financial, profit making instruments, does have an ugly side to it posing a variety of disadvantages. Credit if mishandled or doled out excessively culminates into large scaled financial crises. It has far reaching consequences on all individuals within an economy irrespective of whether they are involved in the borrowing-lending process or not. Although there are various other sources of disadvantages of credit, these points summarise the basic ones. These disadvantages of credit must not be overlooked while indulging in credit exercises.