Wednesday, September 09, 2009

The Credit Cycle is the Wealth Cycle

Credit has become such a fundamental factor in our lives that we scarcely know how to differentiate it from actual wealth.

That’s one of the basic lessons from the housing and consumption boom… provide enough easy debt for a long enough period and eventually you get an economy that is more levered to assumed future wealth (… often just fictional or wishful thinking) than to current real wealth.

The business cycle has become the credit cycle.

As an experiment… simply consider what the economic trends might look like without consumer debt products.

If you wanted to buy something like a house, automobile or some furniture or access a service like sending your kids to college you would first have to save the amount needed.

So in this fictional (… sadly) world where households operate only in the here and now, you could expect the consumption trends on a macro scale to reflect, more or less, the changes in real wages and savings … the more households earned in real terms, the more they could save and/or spend.

In reality though, especially the reality that existed before 2007, access to credit was so effortless that it no longer mattered whether real incomes were growing or if households actually had any savings, they could expand their consumption of products and services by simply tapping future earnings (i.e. taking on debt is simply promising a portion of your future earnings to creditors)

So, the economy was transformed in a way from one where trends reflected, more or less, real increases in living standards through real increases in real earnings to one where the trends more reflected households access to and willingness to use credit.

Now, if either access to credit contracts or households willingness to take on more debt wanes…. or both… it is tantamount to a loss of income… a real loss of wealth.

There is something profound in that notion… loss of the ability (or willingness) to leverage your future earnings feels equivalent to losing today’s real wealth… households feel or in a sense become poorer from a lack of financialization.

For a much better and more detailed discussion of debts effect on the business cycle take a read Mish’s coverage of economist Steve Keen.

Given this, it’s easy to understand why yesterdays Consumer Credit report shocked economists.

Total consumer credit outstanding (see dynamic chart below) declined by 4.24% on a year-over-year basis… the largest annual decline since June of 1944.

After a stupendous, nearly 20 year run of continuous expansion, it’s obvious that access to credit (widely reported cutting of credit limits) as well as the willingness to access credit are both firmly on the decline.