ELi5: Why is debt so important on the economic system?


I’ve been reading lately both about American history and the establishment of the National Bank, and the loans tried to be negotiated with the Dutch banks during the Independence War. At the same time, I’ve read a lot of folks having their Credit score lowered because of paying off either their cars or their student loans. Shouldn’t it be better if you didn’t ave any loans at all?

In: 3

So the rich people/organizations that loan the money can charge interest and get more money Even if the money doesn’t actually exist yet, they can claim it’s there’s and basically create wage slaves out of poor people who can’t afford to pay them back, AND live.

So a credit score (at least in the US) isn’t a measure of financial responsibility, it’s a measure of financial reliability. That is, a person with a high credit score is someone businesses can rely on to make purchases and pay them off. It’s similar, but not the same. A credit score shows that you are participating in the economy. Someone with no economic activity, while individually well off, may not have a high credit score.

On a nation scale, debt is also good there, as taking on debt is a reliable and efficient method to fund growth. As long as that growth outpaces the interest, then taking on that debt leaves you in a better place, long term. It takes debt to build a business, or a power plant, or factory, but that’s all good debt, because you funded something that will pay for itself eventually. Without taking on some debt, economic and social growth becomes significantly harder. We live in an economic system that demands growth, where stagnation is equal to failure and collapse. It’s not a stable system, nor is it as practical one long term. But it’s the one we’ve got.

Debt is a cheat that allows companies and people to acquire a lot of wealth in the short term ostensibly to buy large assets (like a house or a car) and pay it back over a long term.

Without debt the amount of wealth and buying power in our economic system is much much lower. If you had to save up to buy a house up front, very few people would be able to do that in their lifetimes.

This would inevitably lead to a large class of ‘have-nots’, people that spend their money entirely on living costs like rentals because they can never save up enough money to buy things up front.

Our entire society is obsessed with *keeping up with the Jones’s* and unsustainable economic growth and expansion.

Where things have gotten insane with debt though is leveraging.

Companies for example borrow money using their own company and assets as collateral. The idea being that borrowed money can be used to grow the business and generate more profits that exceeds the interest they have to pay on the loans.

This leads to rapid expansion of business, but theoretically speaking a lot of businesses are so heavily leveraged that they are only 1 economic downturn, or a few interest points away from total collapse at any time!

It’s seen as good business practice, but really it’s economic gambling.

Debt is a matter of formal accounting but the concept of debt is almost built into human civilization.

For example, if there was a small community that shared certain communal efforts like the community gathers together to build each others homes, stables etc. The idea of collective effort to build long term benefits (everyone sharing to build a road, for example) is, by its very nature a debt. Borrowing current effort and paying it back in future benefits to the community.

In the broadest sense, for humans to build civilization and societies, some form of collective effort is necessary. So if someone wants to build a factory, they borrow resources from a communal pool to set up the factory. If they do this right, then the factory enhances the total welfare of the community and the debt is paid back either formally or through the benefit of increased productivity and output.

Let’s say you want to buy a new car.

You could save $400 every month, until you had $20,000 saved and then buy your new car wish cash. The downside to this approach is that it will take you over 4 years to save that money, and you won’t have a new car during those 4 years. This is an even bigger problem when we look at buying things like *land* and *houses*, where it could easily take you 20 or 30 or 40 years of hard saving to be able to buy with cash.

Debt allows you to borrow the money now, buy the car now, and repay over time. The downside is that while you borrowed $20,000 to buy a car, you might wind up paying $25,000 or $30,000 or more over the 3-7 years that you’re repaying the loan, because you also have to pay *interest* on what you borrowed.

When we scale up to government-sized issues, the price-tags get really huge. Paving a road, building a new freeway, repairing water pipes… it’s all really really expensive, and having all that money as cash-on-hand isn’t always viable. You don’t **want** to wait ten years to save enough money to have clean drinking water, you want to do those repairs *now*.

OK, so that’s debt. Let’s talk about *Credit Scores* and credit history.

Credit Scores are meant to reflect your behavior *as a borrower*. Do you borrow a lot of money, or only a little? Do you repay debts on time, or have you missed payments? Do you repay loans according to schedule, or do you try to pay them off early, paying less interest to the lender in the process?

Probably the biggest myth around credit and credit scores is that you only have one credit score that every borrower cares about. Different kinds of borrowers have different goals, and care about different things. Credit card companies like people who borrow a lot of money, always make on-time payments, and don’t ever fully repay their credit card balances. Mortgage lenders like people who don’t have so much debt (or even potential debt) that they might struggle to pay their mortgage, and they like people with a history of taking out structured loans and repaying them on schedule. Two lenders, two different kinds of preferences, and those different needs are never going to be adequately met by a single numerical score.