Question by slim p: what is the nature of credit and why is it necessary?
when did it come about? for what reason?
why was it (or stil is) soo important?

Best answer:

Answer by chutney
One change in the fabric of American finance that is particularly striking over the years is the proliferation of credit and the growth of nonbank financing. The primary creditors of the nation’s debtors are not banks, but are so-called nontraditional lenders–such as GE Capital, the financial services arm of General Electric (which, interestingly enough, provides 40 percent of GE’s total earnings. And you thought GE made money selling stuff!).

This was highlighted in a recent Wall Street Journal piece, where it was pointed out that GE Capital’s total assets of $ 425 billion exceed all but three banking conglomerates. According to the article, banks and thrifts contribute a proportionately smaller share of financing to the nation’s credit market today compared to years past. The Journal comments, “Twenty years ago, banks and thrifts supplied 40 percent of the nation’s credit. Ten years ago, it was 26 percent. Today, its down to 19 percent.”

Credit and finance have become the business of America, no longer dominated by banks, thrifts, and their ilk. The Wall Street Journal notes that approximately 40 percent of the earnings from the companies in the S&P 500 came from lending or other financial activities. Many retailers issue credit cards through banks that they own.

Naturally, the question arises as to what the consequences of such a trend might be, particularly given the quirky nature of credit, soaked as it is in a paper-based monetary system.

The Wall Street Journal reporter opines, “The benefits of this change in the financial underpinning of the economy were evident during the recession. As banks tightened lending standards, alternative lending and capital markets took up the slack.”

He points to the well-publicized zero-percent-financing offers by auto manufacturers and to companies like Boeing Capital, which lent UAL $ 700 million to buy planes when the capital markets shunned them. The old guard of easy credit also helped grease the axles, as Fannie Mae’s and Freddie Mac’s assets have risen 21 percent and 35 percent, respectively, since the end of 2000. These two behemoths alone hold as much mortgage debt as all commercial banks combined.

Bank assets, in contrast, rose “just 8 percent,” the reporter ruefully tells readers.

So here, the unwritten assumption is that keeping the spigot of credit open is better than the alternative. Credit is the fuel that feeds spending, and spending, so the conventional thinking goes, is the key to economic growth. The more companies offering credit, the more readily available it becomes, making everybody better off. Easy credit means easy money, ergo prosperity.

For every creditor there is a debtor

One has to wonder if more credit is a good thing. After all, every dollar extended in credit creates a corresponding liability or debt. In theory, at least, debts must be repaid. The risks of debt and leverage become muted under the sunny optimism of boom-time economics. However, the realities of leverage do not change because they are ignored; like the fundamental forces of nature, suspension of belief does not diminish their power. Leverage in finance is similarly unrelenting.

The economist Benjamin Anderson explained the Great Depression in terms of a great excess of credit. He called cheap money the “most dangerous intoxicant known to economic life.”

“Artificially cheap money,” Anderson wrote, “…created a vast fabric of debt, internal and international. As the volume of this debt grew, its quality greatly deteriorated.” He noted that “the period 1931 to March 1933 saw the progressive collapse of the unsound portions of this vast fabric of debt.”

To take on a lot of debt is to exhibit a great deal of confidence about what lies ahead and in your ability to pay it back. It is also a matter of belief on behalf of the creditor. Debt, in essence, is a bet on a rosy future.

While no one can predict the future, it is safe to say that no one can borrow indefinitely, either, for the simple reason that there will be a limit to what a consumer–or business, or government–can borrow and yet still remain solvent. It is sort of a natural law of credit that as the volume of credit expands to more and more debtors, the quality of such credits deteriorate. Not everyone is creditworthy, and as the pool of credit widens, the fringes are shallower than the deeper center in terms of financial resources.

As Greenspan talks positively about the health of the U.S. banking system, one also has to wonder whether a strong banking system matters, given its diminished role in providing credit (and letting pass, uncontested, the idea that the U.S. banking system is healthy–a highly debatable point). Consensus opinion holds that the Fed has some control over the money supply through its traditional means of manipulating bank reserves and interest rates. How much of that is cast into doubt, since nonbanks are doing the bulk of the lending?

To his credit, the Journal reporter also notes that all this credit has a downside. Steve Galbraith, an investment strategist with Morgan Stanley, is quoted as saying, “Banks are not the place to be looking for the next blowup . . . because of the greater importance of these nonbank financial companies, odds are you’ll get a hiccup in this area.”

Which begs the question: What would the impact be if a GE Capital or Fannie Mae started to have financial difficulties? Would the effect be as deleterious as a failing banking behemoth? And would the Feds bail them out, too? In the span of less than a year, the government has, in one way or another, “saved” airlines, domestic steel manufacturers, domestic lumber producers, and, most recently, American farmers. How likely is it that the government will be able to resist saving Fannie Mae?

Some will advocate increased regulation of these nonbanks to conform with, or exceed, existing banking standards. But these are superficial remedies for a problem that lies much deeper. We’ve had banking regulations and numerous oversight bodies for a long time, and that has not stopped financial crises from developing. The problem is the money itself.

Know better? Leave your own answer in the comments!