Credit

Introduction

Definitions and Basics

Credit, from Dictionary.com

Definition: credit:

• … 5. confidence in a purchaser’s ability and intention to pay, displayed by entrusting the buyer with goods or services without immediate payment.
• 6. reputation of solvency and probity, entitling a person to be trusted in buying or borrowing: Your credit is good….
• 8. time allowed for payment for goods or services obtained on trust: 90 days’ credit….
• 10. a sum of money due to a person; anything valuable standing on the credit side of an account: He has an outstanding credit of $50….

Bonds, Borrowing, and Lending, on Econlib.

A bond is a promise to pay. It is a promise to pay something in the future in exchange for receiving something today.

Promises—that is, bonds—can be bought and sold. The buyer of a bond is a lender. The seller of a bond is a borrower. The bond buyers pay now in exchange for promises of future repayment—that is, they are lenders. The bond sellers receive money now and in exchange for their promises of future repayment—that is, they are borrowers.

Bonds can be traded privately between individuals or in organized markets, called bond markets or credit markets.

You may not realize it, but you buy and sell bonds all the time! Every time you lend someone a few dollars for lunch or borrow your friend’s car in exchange for filling her tank, in economic terms you are buying and selling bonds. Simply remembering that bond buyers are lenders, bond sellers are borrowers, and that they are trading not pieces of paper but promises, can unlock the door to understanding both the vocabulary and the economics of a wide range of economic behavior, from private loans to interest rates to government budget deficits. It’s much easier to understand borrowing and lending than abstract vocabulary like “the bond market”—even though they are the same thing—because we can by think about our own familiar experiences with borrowing and lending….

When you use your credit cards or buy on installment, you are a borrower. In each case, someone—a bank or business owner—lends you the money by directly paying for the goods up front on your behalf. The lender later sends you a bill, at which time you are responsible to pay the principal and any accumulated interest to the lender. In economic terms, every time you use your credit card, you sell a bond—your promise to repay the credit card company in the future.

When you deposit money in a bank, you are a lender! In economic terms, you buy the bank’s bond— its commitment to repay you when you decide to use the money. The bank acts as an intermediary (a go-between) and pairs you with a borrower….

Here’s another example. When you buy a Treasury Bill, you are lending to the government. The government sells its promises to pay in organized markets each week….

Classroom activity. To illustrate these concepts in the classroom, I’ve often held a bond auction in class!

Bonds, from the Concise Encyclopedia of Economics

Bond markets are important components of capital markets. Bonds are fixed-income financial assets–essentially IOUs that promise the holder a specified set of payments. The value of a bond, like the value of any other asset, is the present value of the income stream one expects to receive from holding the bond. This has several implications…

Interest, from the Concise Encyclopedia of Economics

Interest rates quoted by lenders usually include much more than “pure” interest. To persuade a lender to surrender current control of resources, the borrower will have to pay, in addition to interest, an amount that compensates the lender for any costs incurred in arranging the transaction, usually including some kind of insurance premium against the risk of default by the borrower. Someone without an established credit rating who applies for an unsecured loan will typically be required to pay “interest” at an annual rate that is several times the prevailing rate of pure interest….

Credit Union, at Investopedia.com

A credit union is a type of financial co-operative. Ranging in size from small, volunteer-only operations to large entities with thousands of participants, credit unions can be formed by large corporations, organizations and other entities for their employees and members. Credit institutions are created, owned and operated by their participants….

Bank Runs, from the Concise Encyclopedia of Economics

A run on a bank occurs when a large number of depositors, fearing that their bank will be unable to repay their deposits in full and on time, try to withdraw their funds immediately. This creates a problem because banks keep only a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets like government securities. When a run comes, a bank must quickly increase its liquidity to meet depositors’ demands. It does so primarily by selling assets, frequently at fire-sale prices. Losses on these sales can make the bank insolvent….

Bankruptcy, from the Concise Encyclopedia of Economics

Bankruptcy is common in America today. Notwithstanding two decades of largely uninterrupted economic growth, the annual bankruptcy filing rate has quintupled, topping 1.5 million individuals annually. Recent years also have seen several of the largest and most expensive corporate bankruptcies in history. This confluence of skyrocketing personal bankruptcies in a period of prosperity, an increasingly expensive and dysfunctional Chapter 11 reorganization system, and the macroeconomic competitive pressures of globalization has spurred legislative efforts to reform the bankruptcy code….

Housing, from the Concise Encyclopedia of Economics

… Assuming a family can spend 30 percent of its income on a mortgage, even with low 5 percent interest rates a family must earn more than $135,000 per year to afford the median-priced new home. If the above estimates are correct, regulations such as urban growth boundaries, moratoriums on building permits, environmental regulations, and other restrictions raise home prices as much as $300,000 in this county. Put another way, the portion of purchase price paid by residents of Santa Clara County due to regulation is almost enough to buy three complete homes of median value elsewhere in the United States….

In the News and Examples

Todd Zywicki on Debt and Bankruptcy, podcast on EconTalk, March 2, 2009.

Todd Zywicki, of George Mason University Law School, talks with EconTalk host Russ Roberts about the evolving world of consumer debt and how institutions and public policy have influenced consumer access to debt and credit. Zywicki defends consumer credit as a crucial benefit to consumers and that innovation has made credit cheaper and more effective. He also talks about how misleading it can be to look at only one piece or another of credit picture. The conversation concludes with a discussion of the evolution of bankruptcy law in the United States….

A Little History: Primary Sources and References

Deposit Insurance, from the Concise Encyclopedia of Economics

Federal deposit insurance became law for commercial banks in 1933 as part of the Glass-Steagall Act, and for S&Ls in 1934. Although a number of state governments had provided deposit insurance before 1933, most state programs had failed and all had been disbanded by then. The federal program was enacted only after long debate.

The Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) were both established in 1934….

Advanced Resources

Related Topics

Government Budget Deficits and Government Debt
Compound Interest
Real, Relative, and Nominal Prices
Inflation