Sunday, October 19, 2008

The dreaded credit "freeze"

What does it even mean for credit to freeze and why should that be a problem?

Let's look at what credit is. Loans (credit ) are given out to individuals or organizations on the basis of their credit-worthiness. Credit-worthiness is a kind of financial reputation that is usually attained through documented repayment of past credit. Or, in the case of the loan by which I purchased our second car, credit-worthiness is established through family relationship to my creditor (my wife's grandfather). In any case, loans entail some degree of reputability and trustworthiness of the debtor and the creditor's ability to believe in the debtor's reputability.

The giving of a loan requires the creditor to forego the consumption or capital purchases he could have otherwise engaged in with the money. This means that the act of giving a loan has a cost to the creditor. This is a common point of confusion among the populace as the charging of interest (usury) is typically seen as mean-spirited and evil, especially when decent people are bankrupted by loans they cannot afford to repay. Interest is the means by which the debtor compensates the creditor for the costs he is incurring by loaning out his money.

Interest, in fact, is a price like any other. And, like all other prices, interest rates are determined by supply and demand. The fewer people willing to give a certain kind of loan (and the more people demanding that kind of loan), the higher the interest rate will be. And vice-versa for lower interest rates. Interest rates are not arbitrary, they are determined by the supply and demand for money itself.

So, why would someone want to take out a loan? Well, there are lots of reasons. The average person will likely think of buying a car or buying a house as occasions to take out a loan. But why should buying a car or house entail taking out a loan? You might say that you cannot afford it if you didn't take out the loan, but this is not true. If it were really true that you could not afford to buy a car without a loan, no one would grant you the loan in the first place. Think about it. You can afford that $20,000 car and more... you are going to eventually pay the purchase price plus interest back to the bank, right? The missing element is time. You cannot afford the car right now and you do not want to wait until you have saved enough money to buy it.

Let's say you buy a $20,000 car and you will pay $5,000 in interest over the 4-year lifetime of the loan for a grand total of $25,000. Now, you could either wait 4 years and save your money then buy the car (and save $5,000 in the process), or you can pay the loan and interest over the 4 years and have the car now. The $5,000 in interest is the price you are willing to pay to have the car sooner rather than later. Let's say you cannot get to work without a car. You will benefit by far more than $5,000 over the next 4 years by virtue of having a job and being able to drive to it. So, it is certainly worth paying the bank $5,000 in interest over the period of 4 years for the benefit of having a car now rather than 4 years from now.

Businesses make the same calculation when they take out loans. Let's say your manufacturing business could increase revenues by $1M/yr. if you could build an additional manufacturing plant. But, the plant will cost $2M and it will take a long time to build that much capital from your current revenues. So, you go to the bank with your proposition and they loan you the $2M. Over the lifetime of the loan, you are going to pay $500,000 in interest, for a grand total of $2.5M. But it will have been worth paying that $500K extra to get the benefit of the new manufacturing plant now rather than later and after 3 or 4 years your manufacturing plant will have paid itself off and your business will be more profitable than it was before.

When credit becomes tighter (the fashionable term seems to be "freezes"), banks are more hesitant to give loans because the reason credit is tight is that loan defaults are increasing. They want to see higher profit margins on the capital, they want to see price decreases taken into account. They want to see a more robust record of past loan repayment. Some businesses use credit for operational expenses and for these businesses, a credit tightening can mean bankruptcy. This is not so different than the credit-card driven American consumer household which has been sustaining itself on an ever-rising pile of debt - day-to-day expenses being charged to credit is a sure recipe for financial ruin.

I don't see why it's such a nightmare that people who have been living beyond their means on credit cards should now be forced to live within their means. They may have to move to a smaller, less luxurious home. Get a smaller, less gas-guzzling car. Downsize their entertainment system a little. Downgrade their wardrobe and furniture a notch. They will not die.

But the same goes for business. All the empty suits on TV keep talking about the "credit freeze" and how this spells disaster for American businesses. Those businesses for which a credit tightening means bankruptcy ought to go bankrupt because they are misallocating resources. A business which can sustain itself only by spending more than it takes in is unviable anyway. Let it go bankrupt, let those capital and human resources be freed for more productive uses. Yes, this entails some temporary pain and hardship as people are scrambling to find new jobs and lines of work and business owners are forced to liquidate their capital equipment for new uses. In the end, however, it is the best thing that can happen for the economy as the foundation is built for the next wave of sustainable growth built on the solid foundation of fiscal restraint and well-allocated resources.

So, let the credit "freeze up." It's only a problem for those individuals and businesses that have been living beyond their means and thereby misallocating resources.

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