CREDIT = CONFIDENCE

Confidence implies credit and credit implies confidence — one does not exist without the other.

A lender extends credit, and a borrower acquires debt.   Debt is the other side of credit.  A loan only occurs when the lender is confident in the borrower’s ability to return principal plus interest.  Similarly, the borrower is confident in their repayment ability.  Conversely, if there’s little to no confidence, there’s little to no credit. 

Credit exists in a variety of forms with a diversity of lenders and borrowers.  In the ensuing sections, we’ll examine different ways that credit comes into existence. 

Can we actually make credit?  Is it like making sausage?  In some respects, I posit that it’s easier!  What is credit?

Credit comes from the Latin “credere”, meaning to believe.  Dictionary.com says credit is,

“Confidence in a purchaser's ability and intention to pay, displayed by entrusting the buyer with goods or services without immediate payment.” 

You don’t have confidence unless you believe.  

 

Making Credit (Part I)

In December of 2014, there was approximately $18 trillion of credit extended to the United States Government (USG).  That number is now $29 trillion (1).  This is considered funded debt.  Simply put, this debt results from deficits accumulated throughout our history, shortfalls occurring in a fiscal year. The funded debt is 61% larger than it was seven years ago.

The USG has the unique ability to obtain large amounts of credit since the perceived risk of default is small —confidence is high.  The fact the USG, through the Treasury, continually borrows should alert you to our inability to retire debt.  Some will argue that it is not important to ever retire our debt. 

There is another, less tangible form of debt that is called unfunded.  Residents of the U.S. pay a tax for social programs like Social Security and Medicare.  These tax receipts are to be socked away in trust funds specifically for those programs.  Unfortunately, due to demographics and fund diversion, we face an unfunded liability that is orders of magnitude higher than the $29 trillion in funded debt.  This is not debt that circulates in the investment markets but rather a projection of future obligations.  

Government gave the trust funds an IOU for money diverted for other spending programs.   The IOU is simply a promise by the government to pay itself.  This process would be akin to an employee in the private sector having money taken from their paycheck ostensibly for retirement and diverted for other company expenses. 

Consider this unfunded liability as credit extended by taxpayers to these trust funds.  But it’s more convoluted since the trust funds then extended credit to the USG for the credit extended to them by taxpayers! 

In his 2009 book Comeback America, former comptroller of the U.S. David Walker projected this unfunded liability at $63 trillion.  I have seen other estimates placing this number at $115 trillion.  Regardless, it is a number with a many zeros!

 

Making Credit (Part II)

There is also credit in the private sector.  As of November 2021, there is $4.3 trillion (2) in consumer credit (the December 2014 figure was $3.2 trillion).  This consists of revolving credit (credit cards) and non-revolving credit (auto, boat, mobile homes, education, and vacations).  This credit originates with commercial banks, finance companies, credit unions, and even pools of securitized assets  — credit that is bundled and sold to others.  The financial crisis of 2008 and subsequent recession sharply curtailed credit card debt.  Similar diminution occurred in 2020 in response to public policy around SARS-COV2.

More private sector credit comes from mortgages.  At the end of Q3 2021 there was $17.6 trillion (3) in mortgage debt outstanding.  Commercial banks, savings institutions, agency, and government sponsored mortgage pools, and asset backed security issuers create the vast majority of real estate credit.  Unlike the aftermath of the 2008 financial crisis when mortgage debt outstanding fell, this debt increased in 2020 despite a concurrent recession.   

 

Making Credit (Part III)

The Federal Reserve (Fed) is integrally involved in making credit.  When the U.S. Treasury needs to borrow, they sell debt to the public.  The Fed purchases this debt from banks and financial institutions.  Where did the Fed’s money come from to buy this debt?  The Fed created the money by increasing the value of the Treasury’s account.  Presto, the Treasury has its money/credit, and the Fed owns debt.  The ability to “monetize” debt, turn debt into money, is the Fed’s greatest source of wizardry.  This ability circulates additional money in the economy but no wealth.  It is literally something for nothing.  

Another function of the Fed is to facilitate banking system credit.  The member banks of the Fed lend under a practice known as fractional reserve.   Historically, 90% of a bank’s deposits became loans.  These loans flow into other parts of the banking system from which more loans occur.  Additionally, banks issue bonds and other debt instruments, creating a larger pool of funds for use as credit. 

Since credit comes with interest considerations, where does the money originate for the interest.  It could come from new wealth created.  In the case of government debt, where do the hundreds of billions of dollars in annual interest originate?  Answer: the source of the interest payments is the same as the initial credit, which is to say, more credit! Thus, our present credit system relies on continuous amounts of credit creation to feed itself.

By allowing the Fed to make money where none existed, government has a lender of last resort.  Rather than tax, government can rely on the Fed and the debt market.  Politicians and bureaucrats use this to their advantage.  This wizardry simply postpones debt pain. 

 

Making Credit (Part IV)

There are other forms of credit whose sum is in the hundreds of trillions that include:

  1. Foreign government debt
  2. Corporate & municipal bonds
  3. Reported derivatives
  4. Shadow derivatives

An in-depth discussion on derivatives is beyond the scope of this article though I will shed some light on the topic.  Derivatives are contracts and can be an underlying asset. Perhaps the best-known form of derivatives is in the regulated commodity futures market. These are reported derivatives.  In the commodity market, the futures contract serves a form of hedging for a producer or a consumer of some economic good. 

Suppose a corn farmer just planted his crop that he will harvest six months later.  The price of corn on the commodity exchange for delivery in six months is $4.00 per bushel.  The farmer would be happy to sell it for that price if that price were available in six months. To fix the price at $4.00 the farmer can enter a futures contract to guarantee that price.  A cereal company also thinks $4.00 per bushel is a good price.  The cereal company and the farmer enter a contract via the commodity exchange.  Six months later the farmer and cereal company have their guaranteed price. 

The preceding example is one of using derivatives for hedging purposes.  Parties in commodity futures transactions also use derivatives for speculation.  They could enter a transaction without any intent of selling or taking possession of corn.  Despite the bad rap they often receive, speculators add liquidity to a market.  Liquidity is good since it means there is more reliable and consistent pricing. 

There is also derivatives activity that takes place outside of regulated exchanges and is thus unreported.  Hedge funds, pension funds, investment banks and insurers expanded the practice of derivatives by engaging in “over-the-counter” transactions, which are essentially private trades.  The good news for participants is it gives them flexibility to propose deals that would be otherwise unsanctioned by regulated futures exchanges.  The bad news is that investment risk is often unknown, making it difficult to assess liabilities. 

In regulated futures exchanges, everyone knows the price of a bushel of corn.  With these over-the-counter products, it is anyone’s guess.  Derivatives are another form of credit in the economy.  The amount of credit based on these unreported derivatives may dwarf all other credit forms. 

 

Credit in Conclusion

We have credit extended directly to the USG ($29 trillion), in the form of unfunded liabilities ($63-$115 trillion), to consumers ($4.3 trillion), and for mortgages ($17.6 trillion).  If credit equals confidence, then we have well over $100 trillion worth of confidence in these areas alone. 

As an individual, you extend credit to the USG since you’re confident in repayment.  After all, the USG has taxing authority, thus a source of funds for debt repayment.  Similarly, individuals extended credit that are now USG unfunded liabilities, with the same expectation of repayment. 

In consumer credit transactions, the financial institution does not share the same degree of confidence.  To compensate, they require higher interest rates or collateral.  The same applies with mortgages.  The mortgage lender has more confidence than a consumer credit company since their collateral, real estate, is much better. 

We’ve also demonstrated how the Federal Reserve, through its wizardry, can create credit easier than you can make sausage to monetize U.S. Treasury debt.  Any U.S. Treasury debt not purchased by the rest of mankind can be sopped up by the Fed.  How much confidence does the Fed need to have to create credit out of thin air?

Credit is a powerful force greasing the wheels of our economy and shaping perceptions of value and prices.  Confidence underpins our system of credit.  Confidence, a human emotion, can also be ephemeral.  While any economy is subject to ebbs and flows, the sheer size of credit and the ease with which much of it is created, exposes us to financial risks that are difficult to manage.

 

References

 

 

Article contains excerpts from Escaping Oz: Navigating the Crisis by Jim Mosquera.  https://EscapingOz.com