Investing Pioneer – 1:45 PM EST – 12/8/2022
Revolving credit, or credit card use, has been growing in the US economy.
While economists say it is not a direct threat to the financial system, it can serve as a litmus test for debt risks.
High levels of revolving credit can be a red flag for potential financial issues in the future.
The liquidity of the decided-upon medium of exchange is essential to the health of an economy. If the people hoard money, economic growth falters. Contrarily, if velocity is too high (velocity being the average rate at which a unit of money is exchanged over time) high inflation may be experienced.
Societies aim to be somewhere in the middle. Not great inflations or hyperinflation and not great deflations or cascading defaults.
The velocity of currency, at its core, is driven by psychology and fundamental realities (such as interest rates). Manipulating and changing the medium of exchange – be it quantity or type – affects the tendency and ability of people to spend. Gold has by and large been at the top of the hierarchy in terms of the perception of its value throughout history. There are two main factors that made it treacherous for earlier economies that relied on it as the main medium of exchange.
(1) A limited amount is produced and (2) people love to hoard it when they perceive risk in the economy, making it prone to deflationary spirals.
To combat this, currencies of lesser value are introduced. When this is done in a marked manner, Gresham’s law immediately applies, where the currency of lesser value is used for exchange, and gold is stored. In economies vying for liquidity, it has often worked wonders, facilitating great periods of growth. In other instances, people went too far, fueling speculative rallies that could only end as spectacular crashes, sometimes followed by deep depressions.
Beyond the introduction of metals of lesser value as official currency (either bank or state-sanctioned) – i.e. silver and bronze – paper currencies followed as economies evolved. Often times initial large-scale implementations, such as by John Law in early 18th century France, didn’t prove too stable at first. Regardless, the goal was to bolster liquidity.
For consumers, the next great iteration would be credit cards. Though some different principles apply, one of the end results is the same. It improved liquidity.
Though credit cards mainly apply to consumers, the fundamental theme is this: credit with easy borrowing requirements.
Those indebted can suffer greatly during deflations, due to interest costs. During deflations, nominally, cash flow on average shrinks, while interest requirements stay the same.
Therefore, companies that only could come to fruition, or grow to the size they are because of cheap credit often collapsed when interest rates rose. It may come down to a simple inability to service the debt, whether that be due to investments in other companies collapsing, reduced cash flow, or equal but insufficient cash-flow relative to the mounting costs to service debt.
A company may have fixed-interest debt, thus making them less prone to the risks of higher rates but, if the company needs to acquire more credit, either because the business model at its current stage is negative, it may experience the same implosion.
19th-century farmers had to deal with this deflation. Among the indebted farmers, the gold standard produced hatred. In the earlier part, 1890s gold flowed from the U.S. to Europe. It was in the farmer’s interest to protest for inflation, while the powerful bankers at the time, most prominently J.P. Morgan Sr. wanted to preserve the gold standard. This fueled antagonistic narratives toward Morgan and bankers as a whole.
A rather extended period during medieval Europe experienced great deflations as well. Referred to as the great bullion famine, it was a severe shortage of precious metals from the mid-15th to the mid-16th century, attributed to both the flow of capital from Europe to the east, insufficient mining output, and hoarding.
The theme of this article will be the current state of revolving credit for the US economy. AKA credit card use. As of recent, it has been growing.
Economists say, by itself, revolving credit risks aren’t a direct threat to the financial system. However, what it can do is serve as a key litmus test for the state of consumers, and by extension the economy as a whole.
United States personal savings rate, per FRED data, is 2.3%, the lowest value since 2005. Meanwhile, US credit card (cc) debt is $928 billion. Interrupted by pandemic consequences – producing a significant trough – cc debt levels have now returned to and appear they could soon overshoot (if they haven’t already) the decade-long trend line.
Despite rising interest rates, consumers are relying more than ever on credit cards as inflation disrupts the financials of Americans.
As interest rates are lower than inflation, and revolving credit is increasing, the fact is clear: policy remains accommodative.
Accommodative to debtors (though some are now having issues). Just because interest rates rise, and some companies experience some issues doesn’t mean the policy isn’t net accommodative.
Savings are cratering, and credit card debt is rising. Credit card debt represents short-term consumer-oriented debt. This means the inflation will likely be more pervasive, and a pivot of sorts by the federal reserve would lead to a return in inflation.
Why? Because bringing inflation down has the same effect as the deflations of the 19th century, where the deflationary nature hurts debtors. The difference is, the federal reserve is attempting disinflation, meaning reducing inflation, but not causing overall net deflation (meaning nominally, prices on average start to fall markedly).
It is proposed that the consumer could be too reliant on “easy credit”, and a successful attempt of reducing inflation numbers to 2% would create conditions that would lead the Fed to pivot to the extent that it would raise inflation numbers to high levels once again.