After last week’s dense, mathy lesson, we’re taking it a bit easier.
Chapter 9 is about the credit market, and it brings together, in a new context, a lot of the fundamentals we’ve already covered.
Find links to all the lessons in this Crash Course here. If you aren’t enrolled yet, sign up here to get all these lessons emailed to you!
Key takeaways
To start budgeting like an economist, picture a bathtub.
The water coming in from the tap is your income (after taxes), and everything the tub holds is your wealth. Not just money in the bank, but any assets like a car or home. The water that evaporates is depreciation — think about your car losing value when you drive it off the lot. Wealth that is consumed goes down the drain, so to speak.
Borrowing, lending, investing and saving allows people to “rearrange the timing of their spending.” For example, we might take out a loan or charge some items on a credit card today based on the expectation that we’ll have a higher income later, enough to both pay back that debt and fund future expenses.
This is an exchange, similar to others we’ve discussed like hours of work versus free time (Chapter 2) or bread supplies versus their price (Chapter 7). In the credit market, the marginal rate of substitution involves the trade-off between money spent now versus money spent later. But rather than hours of work versus free time, or bread supplies versus their price, our marginal rate of substitution follows money spent now versus later. The indifference curves convey how useful the money would be now or later.
But borrowing isn’t free. Lenders charge interest, which, the book notes, “raises the price of bringing buying power forward .” 👆 You can see how this plays out in Julia’s situation from the book. She will receive $100 later but needs some money now. At a 10% interest rate, she can borrow $91 to spend now and repay plus interest later. The line connecting these points is shaded, showing all the feasible combinations of borrowing and repaying. The line becomes steeper, and the shaded area smaller, when the interest rate increases to 78%.
We see a different version of this chart from the perspective of Marco, a lender. If Marco charges a higher interest rate, the slope in his chart moves in the other direction. He’ll end up getting more utility from his money than Julia. Like we’ve seen throughout the course, just because an exchange is mutually beneficial doesn’t mean it’s fair.
What if Julia can’t repay Marco? Just as employers might take measures to ensure employee productivity, the book points out that Marco might mitigate his risk by setting a higher interest rate or asking for collateral. Julia might put up her home or some other equity that would go to Marco if she can’t pay.
People who start with more wealth tend to have better access to credit, with more favorable terms. In this way, the credit market can also perpetuate inequality. That’s the important takeaway, once you’ve learned to apply economic thinking to wealth, investing and lending. As the book puts it: “Rich people lend on terms that make them rich, while poor people borrow on terms that make them poor.”
Important definitions
- Nominal interest rate: The agreed-upon interest a borrower pays a lender. Taking the inflation rate into account will determine the real interest rate the borrower ends up paying with their increased spending power.
- Credit rationing: The mechanism through which borrowing perpetuates inequality. People with less wealth may get more utility from moving smaller amounts of spending back in time, but can’t afford to put up as much collateral or equity.
More from the show
We spent a lot of time this week talking about borrowing, lending and investing among individuals. We’ll look at financial institutions like banks next week. But it’s important to draw a line between household debt and the debt ceiling lawmakers fight about every couple of years.
The U.S. national debt hit $31.4 trillion in early 2023, and the politicking started once again. Some hard-line Republicans have threatened to let the country default on its debts unless the administration agrees to substantial budget cuts.
“What I really think we should do is treat this like we would treat our own household,” House Speaker Kevin McCarthy said on Fox News in January. “If you had a child, you gave him a credit card, and they kept hitting the limit, you wouldn’t just keep increasing it.”
But economists call this comparison inappropriate. The sheer scale of the government, not to mention its ability to collect taxes, make the dynamics at play very different from even a wealthy household.
Plus, credit card limits are set by lenders to manage their risk. The federal debt limit is set by Congress, not creditors, and emerged from the changing relationship between branches of government during the First World War. Read our history of the debt ceiling here.