Guest Post: The Proper Use Of Credit

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Great fortunes are built on the proper use of credit. Improper use of credit leads to mal-investment and wealth destruction.

We cannot understand our fundamental financial problems if we do not understand the proper use of credit. Credit has a key role in capitalism; credit-starved economies are underdeveloped economies, as economist Hernando De Soto explained in his masterwork, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.
In the chronically underdeveloped economies De Soto describes, households have assets--land, dwellings, small businesses--but since the assets do not have legally recognized status as "property" (because the system for recognizing and registering property is both cumbersome and corrupt), they cannot act as collateral for borrowed capital, i.e. loans.
As a result, the majority of the assets are "dead capital," difficult to sell, pass on to future generations or use as collateral.
Great fortunes are built on the proper use of credit. The borrower needs capital to expand his/her enterprise, and the lender needs a fast-growing enterprise with collateral and an income stream to support a low-risk, high-yield loan.
We can profitably look to Colonial America as an example of a credit-starved economy. In the wake of the Revolutionary war and the ratification of the Constitution (1789), the U.S. financial system was a mess: debts left by the war burdened the new government, which historian Thomas McCaw noted "started on a shoestring and almost immediately went bankrupt."
Differing views on the role of the central government, central bank and credit splintered the political elite, with Hamilton squaring off against Madison and Jefferson (though Madison's views were by no means identical to Jefferson's).
Meanwhile, in the real economy, ordinary farmers and entrepreneurs were desperate for long-term credit to fuel their rapidly growing enterprises. Though states were banned by the Constitution from issuing their own currency, states got around this prohibition by granting bank charters. The banks promptly issued the credit that an entrepreneurial economy needed.
The political elite, regardless of their differences, were appalled by this explosion of privately issued and essentially unregulated credit, but this access to credit--turning "dead capital" into collateral--fueled the astonishing growth of the U.S. economy in the 1790s and early 1800s.
The American economy in this phase was anything but orderly or well-regulated.Wild and risky better describe the financial and commercial chaos of the era, but this untamed capitalism led to more successes than failures, and the bankrupt enterprises and busted banks were absorbed by the fast growth of the real economy.
This chaotic explosion of credit and entrepreneurial drive was the opposite of central planning. Risk was everywhere; security in today's meaning did not exist.
The key to the proper use of credit is that it is invested in productive enterprises at a high rate of return. Risk cannot be eliminated, it can only be suppressed or transferred to others. This is the lesson of Benoit Mandlebrot's masterpiece, The Misbehavior of Markets: A Fractal View of Financial Turbulence.
All the complex machinations of the financial magicians in the 2000s to eliminate risk failed, for the profound reasons Mandlebrot explains.
A high rate of return (i.e. a high interest rate) leads lenders to transparently accept risk, and entrepreneurs to only borrow for the highest-return enterprises. A low-yield, high-risk investment is not worth funding. We call these mal-investments or unproductive uses of capital.
In our era, the Federal Reserve and Federal policies have massively incentivized mal-investment and unproductive uses of capital. Low interest rates destroy the needed discipline on both lenders and borrowers to only risk capital in the highest-return, lowest risk uses.
The Keynesian Cargo Cult's blind spot is they do not distinguish between productive and unproductive uses of capital. A bridge to nowhere is equally as worthy as a truly productive investment to Keynesians, because their cult believes that any borrowed-and-spent money is equally good at boosting their false idol, "aggregate demand."
But a truly productive investment of capital has a multiplier effect; it stimulates not just consumption but increased output and productivity. Mal-investments (duplicate MRI tests, McMansions built in the middle of nowhere, etc.) have no multiplier effect because they are simply forms of consumption--they are not even investments, though they are presented as investments by those feeding at the Federal/Federal Reserve trough of zero-interest credit and "free money" distributed by the government.
For credit to be productive, there must first be productive uses for the capital. In an economy with over-capacity in virtually every sector, a massive surplus of labor, a predatory financial sector and a grossly inefficient government in thrall to crony-capitalist cartels, truly productive investments are few and far between.

Instead we borrow trillions of dollars to squander on wasteful consumption and claim it's an "investment." Consumption is not investment, but this simple truth is taboo in our financialized, centrally planned Empire of Mis-Allocated Capital.

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Clowns on Acid's picture

Well thats because Facehook has replaced organized religion as something one should dwell upon.

Now dwelling upon that...I wonder who has provided the cultural impetus behind that?

TheTmfreak's picture

I haven't actually logged on an commented in quite some time. I don't know who this "Charles Hugh-Smith" but sure as hell is a much better one than the typical one. Charles usually spouts socialists drival that is completely ridiculous. However, this article is spot on. Credit should and exclusively be used to provide essential funding to something that will provide continual value, particularly more than it took to get it off the ground. Its really that simple. If i'm going to spend the time working on something, it better put me in a position better than when I started, otherwise I'm wasting time, and resources, thus putting me in a worst position had I done nothing at all.

Landotfree's picture

Charles is an idiot.   If you create a credit system Charles, it will grow until it can't grow anymore, than it will collapse.  It doesn't matter what you spent the credit on!!!!! 

Billions of walking unfunded liabilities will have to go.... they will be liquidated very quickly in many instances from the same tools you created with the credit you extended.  

Architect: Denial is the most predictable of all human responses, but rest assured...this will be the 6th time we have destroyed it, and we have become exceedingly efficient at it.  

scrappy's picture

I agree to your point under the current system.


But the current system wont last friend.


This is better, beyond left and right.



Citxmech's picture

There's a huge difference between "use of credit" and a "debt-based system."  As soon as money is defined as a proxy for debt - the system must collapse absent (impossible) exponential growth, because the interest must be paid in future growth at least the rate of interest (hence inflation of the monetary base as a design feature).

A purely gold-based system could still function with provisions for loans - whether those loans should be flat-rate, equity stake-based, or compound-interest based is another issue however.  Personally, I think compound interest (aka:  usury) is a recipe for disaster, as is project funding through bonds, etc. 

JeffB's picture

"If you create a credit system Charles, it will grow until it can't grow anymore, than it will collapse."

I beg to disagree. I think you are right about what tends to happen over time in a society with credit, but don't think that is a built in inherent part of credit. In a way it is similar to a society's use of fire. We can predict that it will be misused and that people will become careless with it, and even deliberately burn down homes, businesses, start forest fires etc. But I don't think that means fire is inherently bad and should be banned.

" It doesn't matter what you spent the credit on!!!!!"

Of course it does. For instance, if we have two people who both borrow $50,000 and one uses it to gamble, buy drugs and hookers and another uses it to get a degree the outcomes will likely be very different. Or perhaps a farmer borrowing the money to buy a tractor rather than having to use a mule to plow his fields might be a better example. In some cases that farmer might barely produce enough to feed and clothe his family and keep the farm running using that mule and could never save enough to buy the tractor. In the right circumstances buying that tractor might improve his productivity enough to keep the farm going and pay off that loan for the tractor and then some.


TheTmfreak's picture

To prove this point lets take the simplest form of credit possible. The person to person borrow.

Perhaps I have a friend who is handy at slapping together custom tools. Generally he does it for himself to solve whatever problem he's working on, however, its clear that other people have a similar problem, without the skill to develop such tools. He wants to help other people with this problem, but does not have the ability to do it on a large enough scale to help more than the occasional friend.

I on the other hand, have produced enough wealth in my own dealings to have in excess of what i need to survive (capital) and I believe that if he had a little bit of extra money he could spend the time creating the gadgets and sell them to people. I lend him money (credit, with a risk of loss) so that he may do so. In either case, either he is unsucessful but at least we tried to better ourselves and other people's situation, or we succeed, to where he can return my money (with excess since i was willing to risk my money for this idea). He wins (is better off than he was). I win (better off than I was) and those buying the tools to help them solve their own issues win (better off than they were.)

That's productive credit.

Even buying an IPhone on credit could be a productive use of credit, so long as the IPhone provides more value than you paid for it (you use it to track orders, to make call to suppliers, check business mail, scan packages as they come in, process credit cards). Using it however, to text your buddies and look at youtube videos however, is consumptive and a poor use of credit.

Joe Davola's picture

...massive surplus of labor.

Don't view them as surplus labor, view them as spare-time rich, scrip-poor consumers.

NoDebt's picture

Agreed. Great article. Covers all the important points in just a few paragraphs.

But also depressing.... there isn't much in the way of "new game-changer" technology or ideas out there to invest in.

From my perspective as an observant nobody, innovation slowed to a crawl just after AOL started mailing floppy disks to everyone. Ooooo.... let's see what this "inter-webs" thing is! Ooooo.... chat rooms. Ooooo..... message boards and online games!

After that.... mostly just incremental improvements on old ideas. Just consume for the sake of consumption because we don't really know what to do next.

Look at the new Camaro and Mustang, for instance. They designed to look like the ones from the 1960s ON PURPOSE! Sure, it's kinda cool (I'm a car guy so believe me, it's cool) but it also speaks to a certain amount of lack of imagination and innovation. Like worshipping a sports hero but never even suiting up and walking on the field yourself.

tango's picture

If you thinnk innovation is on the way out you are woefully misinformed.   The explosion of knowledge in almost every scientific field is utterly astounding -from computers to materials to chemistry to medicine. The advances in nano are increasing efficiency across the board and smart materials are set to replace A/C.  The discoveries o today are much more profound than a Camaro or fancy phone.  The message board, online games, etc are simply sideshows to the overall arch of the rapid exchange of ideas.  And that rate is incredible,  My son (a computer engineer) told me 2 years ago that CDs would soon disappear (my IMAC has no CD drive) and now smart phones will be replaced by more powerful smart wear  - watches, hats, glasses.  Technology is one of the few endeavors that continually drop in cost while delivering greater returns with each generation. 

Citxmech's picture

I look at this more as an example of decreasing marginal returns.  The price/cost per unit decreases, the development costs increase, profit stagnates as each "innovation" produces less tangible benefit.  Consumption is driven more by planned obsolescence than functional improvement.

Medicine is a perfect example.  Each new drug costs exponentially more than the last, and generally have more side-effects.  The low-hanging fruit has been picked.  Develpment costs - along with gouging, are making the entire health-care system unsustainable.

Honestly, what benefit does a "Google Glass" HUD really offer for those who want to listen to music over say, and iPod/phone-based MP3 player?  Does having you facebook wall projected into your view all day (along w/the obligatory bullshit adds, of course) provide you with any benefit?  Great - now everybody can be even more distracted than before playing Solitare or Angry Birds while stubling down the street.

Another example - our office is now "cloud-based" - what a crock of shit that turned out to be.  Slower, more disruptions, less secure.  The newer versions of older programs are the same way.  Wow, the new version of Word changed everybody's life, huh?  

A new Honda does nothing better than my 6 year-old paid for Honda - sure it's got more bells and whistles - but wtf do I need a touch-screen in my car for?  Is it worth the extra needless complexity and cost?  My paid for '90 Dodge Ram has all of the utility of a new truck at 1/10 the cost - and it's simpler and more reliable to boot.  This is progress?  Oh, that's right, I don't get the "advantages" of being tracked by Big Brother in my old truck.

IMHO the greatest opportunity in innovation will be in localizing economies and doing more with less, not providing more drama w/less content.  As resources become scarcer, population increases, the transportation sector collapses, and infrastructure crumbles, TPTB sell excuses to support a fiction rather than encouraging folks to focus on resiliency.


DosZap's picture

Well it was just a matter of time dudes..........

Vashta Nerada's picture

This is the key takeaway:

The American economy in this phase was anything but orderly or well-regulated.Wild and risky better describe the financial and commercial chaos of the era, but this untamed capitalism led to more successes than failures, and the bankrupt enterprises and busted banks were absorbed by the fast growth of the real economy.
Edmond Dantes's picture

The proper use of credit? Fund every purchase with a reward-friendly credit card, pay off monthly balances in full, roll generated rewards into gold and silver.  Bada bing, bada boom.  Exploit the system to get back at the system. 

DaveyJones's picture

"For credit to be productive, there must first be productive uses for the capital."

only academia can turn common sense into an abstraction  

Imminent Crucible's picture

Yes, and one other thing. It's a fine essay, but Smith needs to learn the distinction between credit and capital. Credit is a debt that must be repaid; capital is savings, better understood as deferred consumption.

You can substitute credit for capital in the economy, but not without very adverse consequences--not the least of which is overexpansion of the money supply, resulting in first asset price inflation and then commodity prices exploding. We're in stage 2 inflation now, with the public becoming aware that the Fed is systematically shredding their purchasing power.

Dr. Kenneth Noisewater's picture

It's actually less 'exploiting the system' than 'clawing back money that is baked into the price anyway', unless you get a cash discount matching or exceeding the merchant's credit card fees.  

Citxmech's picture

Wtf is your avatar exactly?

Or do I even want to know. . .

francis_sawyer's picture

Infinite Growth on a Finite Planet


So Long & Thanks for all the Fish

DaveyJones's picture

and as a result, infinite lies on a finite planet

Downtoolong's picture

Consumption is not investment

Please tell my wife. She claims to have saved $1 million buying shit on sale, but everytime I ask her for the savings account statement she just gets pissed at me and goes shopping.

Bearwagon's picture

Okay, just gimme your number and I'll ring her up and tell her  ;)

Edmond Dantes's picture

Simple solution; use mind tricks to convince her that shopping for precious metals during dips constitutes both "shopping" and a "sale".  She can even (gasp) shop from the comfort of your guys' own home.   

Bearwagon's picture

Or save yourself some effort and just hypnotize her. See Milton H. Erickson "My voice will go with you" ...

Iconoclast's picture

Spend any on sex toys? If so forgive her, so long as she uses them on you and you're not her gimp ;-)

Stockmonger's picture

Paul Krugman says you're crazy, and he has a Nobel Prize.  Spending is wealth.

All you have to do is spend now, and by definition this raises GDP now.  It's best if this is spent by wise government planners on politically correct infrastructure.  Everything else is outside the scope of the DSGE model.

Dr. Kenneth Noisewater's picture

Yep..  Go out and break a bunch of windows today!

Michelle's picture

Show me the next great paradigm shift and money will come running. Trouble is there is little demand for credit because there is little meaningful innovation and until this changes we will continue to have a misallocation of capital.

SheepDog-One's picture

'The Proper Use of Bolts and Padlocks'- 

The expose' comes out years after the horses are gone and died.

Osmium's picture

My version on the proper use of credit.  I have a store issued credit card.  They give me 1 point for every dollar I charge on the card outside their store, and 3 points per dollar for every dollar I charge on the card inside the store.  


 Sometimes they run specials where I receive 5 points per dollar on every dollar I charge inside the store.  I never carry a balance on this card.  Whatever I charge, I pay.


2500 points = a $25 dollar gift card which they send in the mail.  This store sells many things, but guns and ammunition are some of the things they sell. 


 Last year I received $400 dollars in gift cards for items I purchased, but instead of paying cash,

I used their credit card.  So basically, I received $400 in free ammunition.

writingsonthewall's picture

You - like most people - think you are being 'clever' - when you are not

The truth is that store already made it's $400 (and more) from profit on the previous products you bought. I would guess you could have spent $400 less by purchasing elsewhere. (that's why they make the only real offer anin store one)

I mean which is more likely - you have found a chink the armour of a corproation's deal setup by it's marketing department - or you just got hoodwinked (again)

People thinking they are 'winning' is the reason we get into such financial messes. You're buying stuff you don't really need, paying more than you need to - and claiming you're getting a good deal so you don't look stupid.

Does that sound familiar? - think of the US housing market.

Larry Dallas's picture

This is no different than those tv shows that focus on "extreme couponing".

Really, who the fuck needs 24 bottles of 32 oz ketchup.

Financial education for the sheeple by the corporations. Just makes the poor, that much poorer.

El Diablo Rojo's picture

I don't care about credit.

Why isn't anyone talking about the beat down Gold and Silver are taking?  WHY? This shit is outrageous.

writingsonthewall's picture

As credit unlocks future demand (advancing the value of your SOLD house - before you sell it) - then one could argue it's the flaw in Capitalism.

Without credit people would have to accumulate their capital - through wise investment and contracting out their labour.

However credit reduces the benchmark for scrutiny as people are far more likely to waste unearned capital - or capital which appears to be unearnt. (think about a loan for 100k on a house which falls in value to 80k - you effectively got given 20k)

Credit also allows the cycles to last longer - making them bigger - and conseuqently their fall harder.

However, none of this really matters when you look at what credit has actually been used for. Marxist theory still holds that the surplus value was extracted from the economy in the form of profit (which wasn't re-invested but 'saved') - as a result the worker could no longer afford to purchase the same goods and services he is making  / providing.

You can see this in evidence - when was the last time you saw a business growing organically? Every 'entrepenuer' I know - their first stop is the bank for lots and lots of cash to buy 'stuff' for the business - again waste is present

Credit helped him fill that gap - in a classic 'kickthe can down the road' style which most people accuse the Government of. This action has allowed companies to keep wages low when the labour force should have been dragging the capitalist to the negotiating table a longtime ago.

Now it's all too late - everyone blaming everyone else and nobody understanding anything.

Everything is now 'after the fact' - people are arguing about how this plane will crash - nobody is interested in why we're crashing in the first place.

It's there for all to see - and so many choose to accept alternatives.

IamtheREALmario's picture

Very clear and concise.

The thing that worries me most is that even though this is clearly obvious, those who run the banks and governments as well as those whose great grandparents were productive, seem addictied to their parasitic existence. Not only that, they believe because they are the vendors of money or laws or family fortune, they are in some way better than those who actually contribute to the world.

The world "elite" is a sick, ironic joke ... and I believe deep down they know it too.

Debugas's picture

In an economy with over-capacity in virtually every sector, a massive surplus of labor, ... truly productive investments are few

Now let's ask ourselves - do we have over-capacity because we do not need the products or do we need them but simply have no money to buy them ?



IamtheREALmario's picture

Instead of repairing and improving our infrastructure and future existence we buy toys, buy fictcious financialized assets and prosecute wars on helpless innocent people.

There is also the global imbalance. We have a billion Chinese, sacrificing their own existence to produce for a couple hundred Americans. ... and then there is automation which if used properly should be used to allow people the time for continually learning and greater pusuit. But instead we use it as a means to deprive people of existence and their future... because of misallocation of money to those who neither need nor deserve it.

Sandmann's picture

Those toys might include F-35 jet fighters. After all the little homily above ignores the STATE funding itself without voting TAXES. We saw this over Vietnam and the use of inflation and trade deficits to mask Overspending and we see it now using QE to create Magic Money and in between we had Volcker pushing the US Dollar higher as Reagan funded a weapons bonanza on Treasury corporations like GE take out RCA for its weapons manufacturing and sell off itrs consumer franchise to Thomson of France

writingsonthewall's picture

This is not new - this is marxist overproduction.

It's inevitable in captialism - and yet here we are - acting all surprised - that it's reared it's head yet again.....

Sandmann's picture

No. It is Commoditisation concomitant with Under-Consumption because Credit has bee  used for decades as a social lubricant to cover for increased income inequality and a huge shift in GDP towards profits which evade taxes leaving the expanding State to gorge on wages and households to feed its insatiable appetite.

writingsonthewall's picture


That's inaccurate - there has been no underconsuption - and certainly not in America.

I realise you're desperate to blame the Government for everything - but it was the excessive consumption of Americans - supplemented by DEBT - which caused the massive shortfall in demand.

The ONLY debate left is who should fill that demand gap - or if it should be left to rotuntil it clears (which nobody knowshowlong that couldbe) - because clearly 'fixing the root cause' is too much for the average man to consider.

I am amazed that still you seek to blame the Government for the actions of individuals andcorporations.

American citizens have a lack of responsibility.

JOYFUL's picture

De Soto wrote a far more insightful and ultimately, important book - El Otro Sendero(The Other Path)-  which had within it the seeds both  a powerful deconstruction of modern 'capitalism' and the beginnings of an alternative to it and it's alter ego of the time, "communism' ...

unfortunately, one of the greatest tricks of that same 'modern capitalism' is to appropriate and adhere everything to it's venus-flytrap like that in the end, de Soto's work could be quoted approvingly by poltroons like Geo Bush and added as upholstery to the mythos which still sustains the fraud known as 'western civilization.'

"The Other Path" explored the nature of 'black market' economies...not illicit ones, as the term has come to mean in the age of post-Bushey Bandit crony capitalism, but economies outside the protection(racket)of bureaucracy and the state...self organizing communities for whom common interest dictates cooperation and trade...without recourse to tax-provided services of the kind that the welfare state always 'provides' at a higher cost than real people can really pay...except in blood!

It was really a miracle of insular bourgeois thinking that the whole phenomena needed to be packaged up and described the way De Soto did(apparently it is the belief of the privileged classes that without the blessing of their legitimizing state sanction, 'the people' would be no more than savage beasts!)but he did do a great job of showing how creating and sustaining 'market' economies is a natural human trait which needs no outside 'hand' - higher or invisible as the case might be - to encourage or control...

thirty some years later, clearly the edginess of the author is mellowed, and his narrative is beyond all doubt a kind of endless 70's\80\s rockgroup reunion tour kind of sparkless mishmash...all the same instruments are there, but no more fire. It's a cruel joke to see his name here, used to expedite an argument for 'property rights' as the keystone to social wealth and credit...

how very few amongst us can see that the role reversal coming dead ahead will leave 'the west' and 'the rest' in very different positions than the hollow pontificating of both the author of this piece, and the once canny de Soto can see...just like the death of the original Hernando de Soto(along the Mississippi)had to be concealed from the Injuns by his men, (he had claimed to be an immortal "SUN GOD"), so the death of the myth of capitalism needs concealment long after it has narratives like this one!

IamtheREALmario's picture

The idea of communism as in "we are all in this together" is a high and admirable ideal. Unfortunately man's application of communism has been anything but ideal. Communism has historically been implemented through evil means, principally deceit and murder, oppressing the masses equally so that the few parasites can live off them. We can never shake ourselves of those who believe that they are God's gift to man and without them we would all be savages ... whether capitalist parasites, monarchical parasites or communist parasites.

The problem with modern day capitalism, as with communism, is the people who administer it, not the systems themselves.

Sandmann's picture

Communism is crap. Marxism is drivel. It is basically Secular Judaism with a mIllennialist bent. It is based upon crap economics using Smith and Ricardo with their Labour Theory of Value married to the politics of the Paris Commune. Socialism of the Marxist-Leninist Variety has everywhere required Slave Labour Camps to make it function and they operated just as the SS-Labour-Leasing business functioned for IG Farben, cheap disposable labour. Stalin recruited for the Gulag to meet the Five Year plan. Norilsk Nickel would not exist but for slave labour, nor Kamchatka gold mines. Factories in labour camps are common in USSR and China.

Communism is complete and utter crap. It has no redeeming features. It is Evil. It is simply Absolutist like the Pharoahs in Egypt

JOYFUL's picture

As long as we're making a bonfire of previous era's vanities, let's not forget to fuel it with all of the available kindling...

communism's identical twin in the hade's-spawned ideological struggle of talmudic cabbalist dialectical-materialism to pollute and plunder the west was that facade foisted upon a fine tradition of 'free' enterprise under the phoney label of 'capitalism'...

the very same 'secular' judaics as used Smith and Ricardo for one prong of attack upon us would employ the same for the Rothschilds-led drive to hegemony under the rubric of 'market capitalism' - a card trick played upon the peoples of the west with great success right up to the present moment.

And unless that changes very soon, factories in labor camps will be a far more common componet of life in the formerly free 'first world' than in putative legacy socialist zones outside its bounds!

Debt Slave's picture

Proper use of credit: BTFD on PMs and then pay off ASAP. I did it in 2008 and even with interest of 8.25% it was a BONANZA by the end of 2009.

Bearwagon's picture

And by all means HOLD ON TO your PMs ;)

writingsonthewall's picture

It's comment like this which have ruined ZH.

I used to come here for the insight - now it's become popular and attracted all the simpletons who have grasped some basic concepts by the tail end.

People should be banned from posting any of the following - unless they can evidence or explain why it is true.



FED Buying treasuries

...because simply repeating the same shitover and over - and sometimes adding 'bitchez' does not make this site look clever.

We used toget insight and serious economic debate in the comments - now we get morons schreeching about gunsand gold - without realising we're in this shit because of their simple take on everything (like credit) and that their very adherence to Gold (without understanding why) is producing a new bubble - as it seems it BitCoin.