A major difference between cash and credit is that when you settle a transaction in cash, it is settled immediately. When you settle it with credit, you are “starting a tab.” Each such transaction creates both an asset and a liability. The asset and the liability remain until you pay off the debt and the transaction is settled.
The shocking truth is that what most people consider money is in truth credit. The total amount of credit in the United States today is somewhere in the neighborhood of $50 Trillion, while the amount of actual money is only about $3 Trillion. Economies with credit can “heat up” quicker than hypothetical economies without it, but the boom times cannot last because, at some point, the debt must be repaid.
So is credit merely an evil that causes painful economic cycles? Not necessarily. It is evil when it fosters overconsumption that borrowers can’t pay back. It can be a good thing when it efficiently allocates resources. This usually happens when people intelligently use credit to increase productivity. It is especially valuable when it increases productivity driven income above the amount borrowed, which leaves the borrower in a better position despite having to pay off the debt. Buying an awesome new 65-inch television on your credit card is stupid because it doesn’t generate income to help you pay back the debt. The bottom line is that credit is only good when it helps you make more money than the credit costs. Borrowing money from your parents to take a college class that gets you a raise at work is an excellent example (assuming that Mom isn’t charging you too much interest).
The result of all of these increases in spending and paying back debt, we eventually reach an inflection point. An inflection point is a point (usually on a graph) where the trend reverses and starts to go the other way. This is what causes the short-term debt cycle. The early spending (largely on credit) phase is usually referred to as an (economic) expansion. During this time, spending continues to increase, and prices start to rise because the supply of money and credit outstrip the production of goods. We pay more to get what we want now.
When prices rise like this, we call it inflation. The central bank likes a little inflation (say around 2%), but they will take action if it gets much higher than that because high inflation generates problems. The most common way to deal with rising inflation is to raise interest rates; the higher rates make money more expensive to borrow, and the credit cycle slows down. You can think of this as being like the monthly payments on your credit cards going up. You can’t afford to borrow any more money because it is more expensive to pay for what you already borrowed. The lack of cash (it’s going to pay off debt) and the lack of credit (you’re already extended) means that spending slows down.
When spending slows down, none of the people that you were buying stuff from are making as much money, so, in turn, their spending slows down. In this way, the interest rate can be used by the Federal Reserve as a thermostat for the entire economy. When people are spending less is that prices go down, which is called deflation. Economic activity decreases across the board and we have a recession. If the recession gets too severe and inflation isn’t a problem, the central bank will lower interest rates and cause the economy to pick up again.
This works because with low-interest rates, debt is reduced. The cost of borrowing money is cheaper, and people and businesses are more likely to borrow. That borrowing results in increased spending, and the cycle starts all over again. We see another expansion. We can talk about these effects in terms of credit availability. When credit is easily available, there is an economic expansion. When credit is not easily available, there is a recession. Whichever way the economy is moving, the central bank usually has a hand in it. These short-term cycles tend to last from five to eight years, and they happen over and over again for decades.