World Without Credit: Utopia, Dystopia, or Neither?

Credit has become so ingrained in American culture it’s hard to even imagine what a world without credit would look like in its absence. Credit card? Credit. Car Loan? Credit. Mortgage? Credit.

For the sake of this hypothetical article, I will use the terms credit and debt interchangeably. How would the world look without credit? It’s a great mental experiment.

Inherently Good or Evil?

Credit has become one of the most politically loaded issues, and it engulfs an entire spectrum of emotions. From the national debt, healthcare, student loans, buying a home, credit touches all of our every day lives.

Personally, I believe credit has become far too ideological of an issue, and this article will shy away from ramifications. Is credit inherently good or evil? Well, neither.

Credit is marvelous when it bolsters productivity and generates income producing assets (factories, machines, IT hardware).

Contrarily, using credit to purchase non-income producing consumer goods can create massive strain on an individual’s long-run solvency prospects.

The culmination of debt burden trends becoming unsustainable poses massive systemic risk. This is the risk that leads to deleveraging and a deflationary spiral seen during the 1930’s Depression and Japan.

Credit is neither inherently good or evil, and the answer lies somewhere in the middle (like everything in life). Nevertheless, this fictional piece will take you through a world without credit!

Formal or Informal

Credit can be informal (bar tab) or formal (bank note). Credit is merely a promise to pay in the future for something consumed or produced today.

Sure, there are advanced contract laws (Uniform Commercial Code), but I think the bar tab is the best, and most familiar, example.

Imagine you walk into a pub and order a drink. The bar tender pours your order and asks if you would like to start a tab or pay now. You believe you’re going to have 2-3 drinks, so you opt for opening a tab.

Wallah, you have just created credit! Seriously, right then and there! You promised to pay in the future for something you are consuming in the moment.

If you were to view this transaction through the lens of financial statements, the bartender would have an asset titled “Receivable – Bar Tab “Jane Doe”, and you would have a liability called “Payable – Bar Tab”.

Your Debt = Someone’s Asset

Using this simple example we can see that your credit (debt) is a liability for you and an asset for someone else.

This is an unrelenting truth across all credit transactions and is the backbone of double entry accounting. There will never be a moment where your debt is not another’s asset.

“But, what if you default on your debt?” Great question, and we will address this matter later!

Most financial wealth in the United States is simply someone else’s promise to pay future debt. Mortgage bonds, car notes, credit card receivables, and corporate bonds are all simultaneous assets and liabilities.

Banking System

The most apparent place to begin our imaginary scenario is the banking industry. I mean c’mon, the banks make money by lending deposits.

Historically, there have been two competing bank business models: providing storage for valuable possessions and lending deposits for interest.

Let’s begin with the first business model: storage. For a fee, bank branches offer “safe-deposit” boxes, which can store jewelry, precious metals, cash, and important documents.

Safe-deposit boxes are placed under 24-7 security, require two keys, signature and matching identification, and have fire protection.

There are valuable items that you simply would never store at home or under your mattress. The world is chalk-full of risks: fire, natural disasters, and burglary.

The next business model is lending deposits for interest (also known as “fractional reserve banking”). Say you deposit $1,000 into a simple savings account.

The bank typically has a reserve requirement (let’s say 10%), so $100 will be kept on-hand for liquidity management.

Then, the outstanding $900 would be lent to borrowers for various purposes: car loan, mortgage, personal line of credit. Fractional reserve banking would be impossible in a world without credit.

All $1,000 would need to be kept because making loans creates credit. The explicit downside is the lack of funds for business growth and investment.

No lending and credit creation would solve the largest problem plaguing banking, asset-liability mismatches/bank runs. However, why would you deposit money in the bank for no interest?

Heck, I bet some of my ancestors would rather bury the money in their backyard! At least they know it’s safe and under their personal protection.

Corporate Capital Structures

Moving on to business capital structure and corporate finance! Most investors know the Warren Buffett traditional equation for fundamental investment valuation.

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A firm’s intrinsic value is the sum of future free-cash-flows at some long-term discount rate. The discount rate varies by investor but common practice is sovereign debt risk-free rate or the WACC.

WACC is a firm-specific “weighted average cost of capital”. The basic components deriving the cost of capital can be debt, preferred equity, or common equity.

Well, we can throw out the WACC because there would be no cost of debt (all equity financed). The cost of debt is lower than the cost of equity due to capital structures, interest, and bankruptcy protections.

Meaning, businesses would have higher WACCs, resulting in substantially lower firm valuations. Lower valuations mean lower stock prices, and this invokes substantially smaller paper wealth.

However, on a more positive note, firms would be far less prone to bankruptcy. A company “goes bankrupt” when they are unable to meet their debt obligations and restructuring fails.

Running a Business

Payroll is another form of credit; employees work “on credit” and are paid on some schedule. Payroll is one of the best expenses for business owners and improves working capital.

The best expenses are the ones you can deduct today and pay tomorrow (payroll). The worst expenses are the ones you have to pay today and deduct tomorrow (depreciation).

Without credit, employers must pay their employees every day (or hour/minute/second). Obviously this would be impossible, but hey, this is my theoretical story!

Now, how about vendors, suppliers, and dealers? Aha, we have arrived at the chicken and the egg problem.

“How am I going to run a profitable business if I can’t borrow the money to buy raw materials from the vendors and suppliers?” So what, maybe you have enough equity capital to produce a product.

Who’s going to buy from you if your dealers and customers don’t have access to credit? Think about manufactured products from Caterpillar, John Deere, and Kubota.

Is a farmer or construction company going to have hundreds of thousands of dollars to buy those finished goods?

Even worse, there are revolvers, lines of credit, and working capital for the cash conversion cycle. Credit is the grease that keeps the squeaky wheel turning for most businesses.

As we witnessed in 2008, a dramatic decrease in credit poses a systemic risk towards unemployment and bankruptcy from a short-term liquidity squeeze.

No Credit Cycle

As history has pressed forward, economists tend to agree that the “economic cycle” is more-or-less underpinned by the nation’s credit cycle. Why?

Borrowing money and spending on credit automatically creates a mechanistic cycle. This is another unrelenting law of nature. Spending more than your income today requires spending less in the future.

Total spending is the sum of income and credit. As an example, say you earn $100,000 in income and have access to $20,000 in credit. Your potential total spending is $120,000.

Well, your spending is someone else’s income, just as your income is someone else’s spending. However, there will come a time in the future where, to repay the credit, you must spend less than your income.

When you spend less than your income, someone else’s income subsequently decreases, and it leads a cycle throughout the entire economy.

a world without credit has no debt cycles
Source: Ray Dalio “Big Debt Crises”

This doesn’t mean events are predetermined and time specific, but the mechanics of the cycle are fixed. Keynesian, Chicago School, and Austrians all agree on this central economic thesis.

No borrowing and spending on credit can eliminate the credit cycle, but there is a trade-off between growth and investment.

Growth and Investment

The International Monetary Fund unveiled a great read called “Debt and Growth: Is There a Magic Threshold?”

“We find evidence that the relation between the level of debt and growth is importantly influenced by the trajectory of debt

For example, we have found some evidence that higher debt appears to be associated with more volatile growth. And volatile growth can still be damaging to economic welfare”.

In other words, not enough credit can hamper real, productive growth, but too much credit creates unsustainable debt profile trends and ultimately harms more than helps.

Sovereign Credit

Sovereign credit, national debt, or whatever you would like to name it has a tremendous impact on a nation’s GDP (gross domestic product).

I have developed my very own three-pronged test for sovereign credit: is the credit productive, sustainable, and ineffective by the private sector.

What is an example of something meeting all three requirements?

The National Interstate System. The Interstate System connected states, bolstered GDP, increased tax revenue, and was sustainable over the long-term.

The US Treasury is the executive department overseeing the issuance of sovereign credit and funding for fiscal appropriations. This department would disappear in a world without credit.

Conversely, the Treasury has played a vital role throughout our country’s history, especially during WWII, stimulating during economic recessions, and funding productivity tools like infrastructure and education.

What would happen if sovereign credit disappeared, and would it be beneficial? I have no idea!

Typical Family

Moving from the macro to the micro, credit can be a family’s saving grace or achilles heel leading to impending financial ruin. Money fights are the number one cause of divorce.

When it comes to using credit my mind always goes back to a hilarious SNL skit focused on buying things when you have the money. The family can’t comprehend the idea of not using their credit card!

What are some typical uses of credit by individuals and families?

  • Credit Card
  • Car Loan
  • Mortgage
  • HELOC
  • Student Loans

My grandmother told me of the days before credit cards. How did you pay for groceries? Cash she said. How about your house or car? Cash and savings. Hmm.

I guess those were cheaper times in the 1950’s, but how could Americans today possibly afford to buy their home outright? They couldn’t, and that’s where mortgages help.

Mortgages allow families to spread the cost of home ownership over 15 or 30 years and lay familial roots! A car loan provides financing for reliable transportation to work, which can boost personal income.

The use of personal credit varies A LOT by country and culture. The idea of borrowing money was foreign to a friend I met from Sweden. He informed me in rural areas of Sweden it is socially unacceptable.

When it comes to personal credit, what’s good for the goose is not always good for the gander; it’s uniquely personal, and there are infinitely different scenarios at play.

Pensions and Retirees

My grandmother is 88 years old, with arthritis and a walker. Life is not always so kind to an aging body, and there comes a point where you will no longer be able to physically or mentally work.

This is exactly where retirement planning comes into play. Financial advisors classify retirement income planning into a three-stooled chair (most stable): social security, pension, personal savings/investments.

Pensions and retirees are heavily invested in fixed-income products (bonds, CDs, annuities) because they provide an income stream with lower risk.

Until recent years, equities were a small portion of investment allocation. How would you invest without debt instruments? The only options are stocks, gold, and no leverage real estate.

Remember from earlier, your debt is someone else’s asset. When you default on credit, unable to repay debt, you default on someone’s asset.

Would a dramatic retirement crisis ensue?

Medical Care

The Journal of The American Medical Association (JAMA) wrote an article titled “Distribution of Variable vs Fixed Costs of Hospital Care“.

“The majority of cost in providing hospital service is related to buildings, equipment, salaried labor, and overhead, which are fixed over the short term.

The high fixed costs emphasize the importance of adjusting fixed costs to patient consumption to maintain efficiency.”

High fixed costs typically require credit for funding. A new hospital building or unit could run north of $100 million. Do you have $100 million? I sure don’t know anyone that does.

Without access to credit, many individuals may not receive life-saving medical care. The life of your loved ones surely has no price tag.

Secondary Education

The best way to improve standards of living are to improve productivity. One of the best ways to improve productivity is to increase human capital. But, what if there were no student loans?

The Federal Reserve found the cohort with the highest spending velocity (college students). Student loan money will be immediately spent on tuition, books, housing, and other necessities.

It’s a great way to juice the economy in the short-run, but how about the $1.6 trillion student loan crisis? Were these loans good for the students hopelessly in debt, and did they increase human capital?

Would people still be able to go to college? That’s beyond my pay-grade and up for you to decide. Just some food for thought.

Speculation

Investopedia has great definitions for speculative mortgage loans.

“A “liar loan” is a category of mortgage that refers to low-documentation or no-documentation mortgages.

On certain low-documentation loan programs, such as stated income/stated asset (SISA) loans, income and assets are simply noted on the loan application.

On other loan programs, such as no income/no asset (NINA) loans, no income and assets are given on the loan application form.

Some liar loans take the form of NINJA loans, an acronym that means the borrower has “no income, no job, and no assets” to speak of.

These loan programs open the door for unethical behavior by unscrupulous borrowers and lenders, and have historically been abused substantially.”

Speculative economic activity poses great risk for an economy because credit crises are always the worst downturns. It’s one thing to lose your own money; it’s another to lose someone else’s.

Without easy access to free-flowing credit, there would be much less speculation. This is a vastly positive force.

Jobs Reliant on Credit

Here are just a quick list of careers that would be negatively effected in a world without credit.

  • Banking
  • Debt Financier
  • Construction
  • Real Estate
  • Land Development
  • Hotels

Remember, their spending is someone’s income.

Religious Doctrine

Finally, what do religious documents say about the use of credit and debt? For starters, it used to be a sin to charge interest in Christian and Islam faiths. Judaism always allowed the charging of interest.

Leviticus 25 in the Bible states, “And you shall count seven weeks of years, seven times seven years, so that the time of the seven weeks of years shall be to you forty-nine years.

Then you shall send abroad the loud trumpet on the tenth day of the seventh month; on the day of atonement you shall send abroad the loud trumpet throughout all your land.

And you shall hallow the fiftieth year, and proclaim liberty throughout the land to all its inhabitants; it shall be a jubilee for you, when each of you shall return to his property and each of you shall return to his family.”

Many scholars have noted the jubilee every 50 years is a reflection of the credit cycle where debt burdens became too high for potential repayment. Who ever said history doesn’t repeat itself?

World Without Credit: Better Place?

Undoubtedly, there is no right answer, and credit varies across the board. Is it productive or non-productive? Does it finance an asset or a liability?

Hopefully, this article did as it was intended and got your mind thinking about the world in a more complex way. Debt is not inherently evil or great; it’s somewhere in between.

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