Last week we added productivity to our model, and discovered that this requires investment, and that investment requires credit.
So this week we’re examining credit in more detail, and in fact credit is a vitally important component to our “engine”. Without it, there can be no economy. This may seem a big claim, but the fundamental reality is that no business can happen in the real world without credit. There’s a very logical way to think about this:
A new business hasn’t got any revenue of its own until it starts selling its products. But it cannot sell anything until it has produced something. And it cannot produce something without purchasing the raw materials and capital goods for production. But it hasn’t got any money to buy them until it sells something….
So you can see, any new business needs credit before it can even begin. We also saw last week how expanding a business, improving efficiency or developing new products requires credit for investment.
But even in day-to-day trading, the reality is that credit is ubiquitous to business. When businesses sell to each other, they don’t physically visit each other, pay on the spot and pick up the goods! One business raises an order, the other arranges delivery of the goods and sends an invoice. Typically, the invoice needs to be paid in 28 or 30 days. That’s a month’s credit. It’s not uncommon to even give 90 days for payment of an invoice. It varies from industry to industry and dependent on the relationship between the businesses concerned. These small timescales might not seem very important, but to understand how business works you have to understand the importance of credit (when we get onto banking, you’ll discover that the overnight lending rate is one of the single most important variables in the entire economy). One of the most dangerous factors in the 2008 crash was that businesses and banks stopped extending credit because everyone was worried about everyone else’s ability to repay – the ‘credit crunch’.
So hopefully you can clearly see that to understand how the economy works, we need to understand the processes by which businesses access credit. It is such an important concept we will be coming back to it time and again.
I also need to give credit where it’s due. The importance of credit to business is fully explained in books such as Richard Werner’s “The New Paradigm in Macroeconomics”; Godley and Lavoie’s “Monetary Economics”; and Stiglitz and Greenwald’s “Towards a New Paradigm in Monetary Economics”. I’m not exactly recommending these books, even though I love the first two in particular and constantly refer to them, but they’re not introductory texts (Werner is the most readable, but I don’t know if I’d recommend it as the first economics book you ever read, though would urge any economics student to read it). I’m just pointing out that there is a rich, evidence-based body of work on the role of credit, and it’s their brilliance that I’m trying to translate into something more accessible and brief.
Coming back to Dynamicland, we therefore need to add a way for businesses to access credit if our model (adding productivity increases to Orderlyland) is going to make sense. But first, I need to show what’s happening to prices as a result of the increases in productivity, which we will do next week.