Credit is what puts America to work

It sounds almost like a Jay Leno line, but there is no better way to put it: We owe a lot to debt.

If credit markets had not developed and become more efficient over the past century and a half, our standard of living would have been stalled in a world of outdoor plumbing, harnessed animals, and, for most of us, a life of backbreaking labor and meager reward.

There is no doubt of the important roles played by inventors, entrepreneurs and even captains of industry. Pretty much everyone knows the story of how the railroads, the automobile, the steel industry, large scale agriculture, and even the Hollywood film industry transformed America and presented it with unprecedented prosperity. The back story, though, is less well known, and very much undervalued.

Almost none of the great strides made in our economic development could have been made if credit markets had not developed to gather individual savings and place them where they could be put to productive use. Our railroads, for example, which brought the first dramatic changes to our economy and our society, were financed principally by British and European investors, something that would have been a practical impossibility if financial markets had not been in place.

Access to credit makes the difference between a company that grows fast enough to fulfill its potential and a company that grows so slowly that it risks being left behind. When we look at a firm’s operating model in stripped-down form, we can see the direct impact of credit on growth. The fictional example below shows how access to credit makes a difference:

Let’s say that JavaWheels is a mobile sandwich, snack and coffee truck that works mostly small and large job sites. It is a new business, started with its owner’s savings, and has no access to credit. Its one truck cost $48,000 and is working at capacity. Its gross sales are $10,000 per month yielding a profit of 10 percent.

If we assume that the firm plows all profits back into the company and that an additional truck placed into service will immediately operate at capacity, a couple of things are immediately clear. The first is that JavaWheels cannot grow until its internally generated capital accumulates enough cash to buy another truck. Until then, its growth rate is zero. Retained earnings could grow at $1,000 a month, and it would take 48 months to save enough to buy the new wheels.

With the second truck in operation, it would only take half as long to save up enough for a third truck because JavaWheels would now be accumulating profits at $2,000 per month — $1,000 for each truck. And if a third truck were put in service, the waiting period would then go down to 16 months.

Of course, it took four years before the company saw any growth at all, and it has now taken over seven years to become a three-truck operation.

If JavaWheels had access to credit, however, its growth would have a different trajectory.

The firm could then purchase its second truck after six months, when it had accumulated enough profit for a down payment of, say, $6,000. That one small change would allow the firm to double its sales for the second half of its first year in business.

Even if we assume that installment loan payments for the truck purchased on credit ate all of its profit, the firm would still be in a position to purchase a third truck at the end of the year — because it would be clearing $1,000 per month from the first truck. Now, after operating for just one year it has tripled its monthly sales.

It isn’t just sales that went up, either. In all likelihood JavaWheels has also increased the number of people it has on the operations side of its payroll. We know that they would need at least two new drivers and, at a minimum some additional labor hours for food preparation people.

JavaWheels is an example and not meant to portray a thoroughly realistic business. But its assumptions and simplicity are enough to illustrate how access to credit can act as an accelerant to growth. And it also shows that when that access is closed off or severely limited — as we’ve seen happen in many areas during our recession — job growth stagnates.

Does this mean that credit is always a more-is-better kind of thing? Definitely not.

But credit, wisely used, can allow a business to take advantage of a market opportunity or a new technology. That’s the way this country was built, and it’s the way it will recover from this recession. There are no substitutes.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.