What is Credit?

Credit is used every day often without us even knowing it.  If you’ve got a tab at the bar they have essentially provided you with credit even though it’s very short term credit.  There’s an illusion that only banks can create credit and some conspiracy theorists who decry the unfairness of this system.  Nothing could be further from the truth.

Credit is incredibly important and in other articles we’ll examine how it works to create cycles within the economy.  The question is what is it?

To be clear, we’re not referring to credit scores here.  What we’re referring to is a means of payment.  You pay with either cash or credit, again not referring to credit cards in this case.  So what is it?

In any transaction there is an exchange a good or service for cash or credit.  Let’s consider what happens in a cash transaction (not referring to physical bills here but where there is no debt created).  In a case such as this I pay you money and you give me a good or service.  Look at our balance sheets.  At the start I’ve got an asset and you’ve got cash.  Then when the transaction goes through we swap.

Before the Transaction

Me You
Cash Goods

After the Transaction

Me You
Goods Cash


Now let’s see what happens if we change this process and instead of paying with cash.

Before the Transaction

Me You
Assets Liabilities Assets Liabilities
None None Goods None

After the Transaction

Me You
Assets Liabilities Assets Liabilities
Goods Debt (payable) Debt (receivable) None

 

Notice what happened here.  Instead of paying cash debt was created.  What is debt?  Debt is an asset for the person who is going to collect the debt and a liability for the person who has to pay the debt.

In other words, credit is when we create out of thin air an asset on one person’s balance sheet with a corresponding exactly equal liability on the other person’s balance sheet.  When the debt is paid off you’ll go back to the way it was in the cash transaction with just cash on the balance sheet of the person who was paid and no liability on the balance sheet of the person who paid.  What’s important about this?  A lot of people confuse credit for money because it can be used as such but credit, which can be issued to an unlimited extent within the confines of physical resources is not really the same as creating money.  It is treated as money in many cases to exchange goods and services but the difference is there is no net growth in wealth because credit cancels itself out.  What it does is it allows transactions to take place sooner, which can help to increase productivity and activate resources in the economy that would normally just be sitting.

Hopefully that gives you a basic understanding of what credit is and how it works.  There’s a lot more to it of course but we’ll cover those nuances in future posts.

If you’re interested in a deeper understanding of credit or any other business or wealth building issue please contact us and we’d be happy to assist you.