Credit Where Credit is Due

This week, in a speech before the London School of Economics, Fed Chairman Ben Bernanke offered a perverse economic theory in his quest to gather support for never-ending Wall Street bailouts; “This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt.” In other words, credit is the lifeblood of our economy, and the continued operation of credit providers is an issue of national security.

In truth, not all economies run on credit. But over the last decade, the United States became a bubble economy that needed unlimited credit to keep from collapsing. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings. It’s too bad our Fed chairman does not understand the difference.

That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken and not encouraged. What we need in America is more restraint and less indulgence. For example, Americans in the current economy should not go into debt to buy new cars. Given the level of debt that weighs down the typical family, Americans should defer such purchases until they have paid down existing debt, or replenished their savings to the point where they can afford to pay cash. Until that time, Americans should continue driving their old cars. In the meantime, the untapped savings could be made available to local businesses that would use it to finance badly needed capital investments.

But such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming Administrations appears willing to consider. By providing perpetual support to lenders who have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.

Credit is indeed vital to an economy, but it does not constitute an economy within itself. The important thing to remember is that credit is scarce, and is limited by the stock of savings. Savings loaned to one individual is not available to be loaned to another until it is repaid. If it is never repaid, the savings are lost. Loans to consumers not only crowd out more productive loans that might have been made to business, but they have a far greater likelihood of ending in default. In addition, while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent, and do not create conditions that will make repayment easier. When businesses borrow to fund capital investments, the extra cash flows that result are used to repay the loans. When individuals borrow to spend, loans can only be repaid out of reduced future consumption.

One of the reasons we are in such dire straits is that consumers have already borrowed and spent too much. Many did so based on the false belief that ever-appreciating real estate would ultimately provide the means to repay their debts and finance their lifestyles. Now that reality has finally set in, why should the spending spree continue? The fact that a GDP comprised of 70 percent of consumption is currently contracting should not surprise anyone. In fact, such a contraction is long overdue and the government should not do anything to interfere.

In trying to perpetuate the illusion, the government wants to revive the spending spree that has led us to this disaster. But how can such actions possibly help? How will more debt improve the economy? Wouldn’t our circumstances be vastly improved if we paid off some of our debts and replenished our savings? Wouldn’t we be in better shape if instead of buying more stuff we concentrated on producing it?

The unpleasant reality is that years of bad monetary and fiscal policy have over encumbered our economy with debt and undermined our industrial capacity. The sooner we can begin to repair the damages, the sooner we can right the ship. If instead we merely administer more of the same, the ship will sink in a sea of inflation.

10 Responses to "Credit Where Credit is Due"

  1. Marcos Lee   January 17, 2009 at 2:09 pm

    I think Peter Schiff is an astute and knowledgable individual when it comes to economic issues.However in this article there are way too many generalizations and assumptions.”That American families now routinely rely on credit to make every-day purchases…” is not true for me and many of my friends and family.”…while business loans increase our capital stock and lead to greater productivity, loans made to consumers are merely spent,…” First business loans don’t always lead to your conclusion, in fact most every business that has gone bankrupt has defaulted on loans and, secondly, consumers do use loans to invest. They invest in homes (new, exisiting and remodels) that strengthen communities, in education loans that provide more opportunities for their children to lead successful lives and in equity loans to launch an entrepreneurial business idea (see Jobs and Wozniak, or Cuban, or how about Sam Walton)!I’m just an average Joe that got much of his retirement investments hammered. I think it’s greed that has created this mess. And it starts with the executive suite. CEO’s that receive ten’s of millions in executive compensation, bankers and brokers that manipulate and concoct investment instruments to increase their profits, and politicians who say they represent the populace but really only cater to special interest’s.I no longer have faith or confidence in our leaders; just in myself.

  2. artichoke   January 17, 2009 at 3:36 pm

    To the extent that Schiff’s generalizations were generally true, there is no problem with them. He was trying to write normally, not like an economist with all the necessary caveats. The message conveyed is correct.New homes don’t “strengthen communities”, or if they do, it’s only though increased property tax revenues. You can have a perfectly good community of small modest houses with fascinating good people living inside the houses.But Marcos’ conclusion is laudable and in the spirit of what Schiff wrote. We need to be more self reliant. And watch our pennies. Nobody else will do it properly for us.

  3. Guest   January 17, 2009 at 5:38 pm

    Sadly Schiff has REPEATEDLY been right, more so that Roubini, who I have utmost respect for. As heartless as it sounds, bad businesses and bad banks need to go, not be propped up. Bad mortgages need to fail and be foreclosed–not rescued. Such behavior has been repeated proven to become a moral hazzard. after all, if the Joneses are not paying their mortgage and getting help from the government to live in a house they couldn’t afford to buy in the first place, why shouldn’t you or you or him, or her? We have all studied the economic behavior of the firm, such as “shirking”. This is shirking at its worst.Read more of his analysis on his website and hear him on the Internet and you will see that far from “generalizations and assumptions” he is simply applying common sense.He called it before Roubini did, not that there is a contest.

  4. Anonymous   January 17, 2009 at 9:18 pm

    I think Peter Schiff is full of shit. This pampered kid born into wealth has no idea about the life of ordinary working people, from paycheck to paycheck. He reminds me the fascistic Zurich gnome Marc Faber, another guru of libertarian cryptofascists. Both want us to believe that man is born for Darwinian existence. This is what Schiff’s “common sense” is all about. So it is personal loans that are more likely to default that business, eh? Tell this to Lehman Bros and Citibank. And taking a car loan to buy a new car to replace the 12-year old one is Un-Anmerican, it destroys our great capitalist economy, eh? So why is it, Schiff, that Americans don’t get paid enough to have enough savings to buy cars that drive them to work?

  5. Joe Plummer   January 18, 2009 at 2:17 am

    Until we address our FRAUDULENT monetary system, nothing will change. For a short, easy and FREE book on the topic, check out:

  6. Liberator   January 18, 2009 at 7:01 am

    The most important thing in Schiff’s piece, to my mind, is his remark that true “credit is scarce, and is limited by the stock of savings.”If credit were offered only from money that others have saved and invested, the present crisis could not have arisen and much of Schiff’s advice would not be needed; to buy a new car on credit, for example, would be a choice to be made on the basis of what such credit costs. Yes, IMO it would cost a great deal more than it does today so purchases of that kind would be much less common; but again, that would be a free choice. Borrowers would compete for the scarce resource.The problem is not so much with credit itself, but with the mountain of false credit built on the government’s “money” system; in a phrase, Fractional Reserve Banking. “Money” is created out of thin air by government fiat, and cooperating banks are licensed to lend nine times more than they accept in first-time deposits. That is the balloon that underlies this mess; that is what makes credit appear so “cheap” – but every penny of it was minted not in boardrooms (where company directors merely take advantage of an environment politicians fashioned) but in Washington, D.C.By the way, “Anonymous” of 1/17, please produce one shred of evidence that Peter Schiff was “born into wealth.” It would make no difference to the validity of his views if he had, but as it happens he was not; and to blame a person for the circumstances of his birth reveals a bigotry typical of racists and slave-owners.

  7. Anonymous   January 18, 2009 at 8:44 am

    In other words, face reality or perish. Mathematics of Rule: Ross(Electronics Design Engineer)

  8. MLK   January 18, 2009 at 10:28 am

    @Peter’sBut such a drastic reversal in financial culture represents the kind of change that no one in the outgoing or incoming Administrations appears willing to consider. By providing perpetual support to lenders who have bankrupted themselves through bad loans, the government merely guarantees that bad economic behavior will continue.I strongly subscribe to the view that why the Government doesn’t enought people to be more frugal and spend within their means. Does encouraging consumers to continuously spend foolish help to resolve the country’s economics problems in the long run?

    • MLK   January 18, 2009 at 10:30 am

      Correction.enought should reads as encouragefoolish should reads as foolishly

  9. Mark Davis   January 18, 2009 at 10:49 am

    Excellent piece. The mirage economy based on deficit financing always reveals itself eventually with profound failure. Economic growth first and foremost requires production greater than spending: savings. Sustainable economic growth requires responsible stewardship of those savings. Fractional reserve banking inherently undermines both. The Grand Illusion will go on until it goes poof!Thank you Mr. Shiff for your honesty and resilience speaking the truth. It is easy to preach to the choir, but confronting fools live on video media forums drowning in superficial understandings takes courage. Lovers of liberty are in your debt.