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Credit is a powerful tool for American families

(Illustration by Victor Kerlow for The Washington Post)

Americans have an ambivalent relationship with non-mortgage consumer credit: We all use it, yet we feel as if there is something slightly wrong about it. Should we?

Consumer credit is often thought to be just a way to live beyond one’s means and to shift consumption – to spend today instead of saving for tomorrow. But the assumption that families use credit profligately is misleading. To understand how consumers use credit – and why it is a boon to American families and the economy – it is useful to understand how businesses use credit.

Businesses use it for two basic reasons: to invest in capital goods and to smooth income and expenses. Capital goods generate a stream of benefits over time – for example, a construction company could employ workers with shovels to dig foundations for buildings or buy a backhoe to do the same work and finance it out of the crew’s increased productivity.

Similarly, businesses can use credit to deal with short-term fluctuations in revenue and expenses – a retailer might finance its operations on credit during lean times and then pay it back when profits return and more inventory is needed.

[Going by the strict definition, credit is evil]

But what is often not appreciated is that households overwhelmingly use credit for the same purposes. Much of our use of consumer credit is for investment purposes, such as to buy a home or to use student loans to increase our human capital and earn a higher-paying job.

But most of our big-ticket expenditures have this same characteristic: cars, refrigerators, televisions and other household durables. Consider, for example, the humble washing machine. Its value is the time and money it saves from not having to schlep to the laundromat every weekend with a pocket full of quarters. Refrigerators save us time-consuming trips to the grocery store or eating out; cars expand our job options. In short, the bulk of non-mortgage consumer credit is used to buy consumer durables that generate a stream of benefits over time.

Like businesses, consumers also use credit to deal with short-term fluctuations in household income and expenses, for example, to finance an unexpected car repair or braces for a child.

Of course, some consumers use credit excessively and get in over their heads. And, one might object, hasn’t the convenience and ubiquity of credit cards turned us into a nation of debt-addicted spendthrifts, unlike the “good old days” when we all lived within our means? As then-professor, now senator, Elizabeth Warren expressed the sentiment in 2004: “The [credit card] industry has no evidence that people were being turned down for loans in the early 1980s. What they have is evidence that people more often in the early 1980s preferred to pay cash than to pay on credit.”

In fact, that’s not what the evidence shows. Although Warren is right that fewer consumers used credit cards before the 1980s, that does not mean that they were instead paying with cash. In fact, the great explosion in consumer credit use was in the postwar period, as Americans abandoned their cramped city apartments and moved to the three-bedroom ranch in the suburbs – with a mortgage, a new car in the garage and all the latest appliances and furnishings, all bought “on time” (according to the advertising slogan of the era).

Indeed, the Federal Reserve’s debt-service ratio measurement of household finances (which assesses the percentage of disposable income dedicated to debt payments each month) demonstrates no increase in the household non-mortgage debt-service ratio in 2014, compared with that in 1980.

But for the extraordinary increase in student debt beginning in the early 1990s (and which is now the single largest component of non-mortgage debt, surpassing auto loans a couple of years ago), this debt-service ratio would be significantly lower than in the 1980s. Credit cards have not increased the debt burden but simply replaced local bank branches, department stores, personal finance companies and pawn shops with more modern and flexible credit choices.

Consider the typical 1970s household. Few households had several hundred dollars in savings to deal with an urgent need to repair or replace a car or stove in a pinch. If they needed $500 for the fix, they might go to a personal finance company or a local bank and borrow the money and repay it in monthly installments. A new bedroom set would be financed from the furniture store, a new suit or bicycle from the local department store, and a new refrigerator from the appliance shop.

Even more perverse were layaway plans, where the consumer paid the business in advance for the goods, enabling the business to earn interest on the consumer’s account while the consumer still didn’t have use of the goods.

Today, of course, most of these purchases would be paid for on a credit card – but there is no reason to believe that credit cards are any more susceptible to consumer misuse than the “easy monthly payments” of bygone days. Rather, credit cards have had major advantages for consumers and the economy.

The growth of general acceptance credit cards (such as Visa, MasterCard and American Express) has enabled consumers to separate the credit transaction from the goods, promoting competition and consumer choice on both fronts. Credit cards have also relieved retailers of the cost and risk of running in-house credit operations and have thereby enabled start-up businesses (including online stores such as to compete with big department and specialty stores.

What about payday lending and similar high-cost products? Academic studies show that those who use payday lending do so because they don’t have credit cards (or are maxed out), and it can be less expensive than available alternatives, such as bank overdraft protection, pawnshops, bounced checks and late bill payments. Eliminating access to preferred products doesn’t eliminate the need for credit.

And what happens if we try to regulate away the supply of payday loans and other similar products? Well, it’s been tried, and we’ve learned – the hard way – that demand doesn’t go away. Eliminating the supply of credit simply turns the market over to illegal loan sharks.

For example, when Anthony “Fat Tony” Salerno, the head of New York’s Genovese crime family, was indicted in 1973 on 11 counts of illegal loan-sharking (and one count of criminal solicitation to have a victim’s leg broken), it was estimated that his operation had $80 million a day outstanding in loans ($429 million in today’s dollars). But Fat Tony wasn’t unique: According to the findings of a 1968 U.S. Senate report on the mafia, loan-sharking was its second-largest revenue source of the time.

Thus although payday loans are expensive and sometimes prone to abuse, that option certainly seems better than owing a leg-breaker with a baseball bat.

The growth of consumer credit in the postwar era has been a tremendous boon to American families and the American economy. Credit has expanded access to the conveniences of modern life that used to be reserved to the few: cars, washing machines and refrigerators. In turn, access to those products has reshaped the way we live and work.

After the financial crisis, Washington stepped up efforts to more tightly regulate financial institutions. It would do well to remember the lessons of history and economics, and be careful about adopting policies that take away the choices that consumers use to make their lives better.

Zywicki is a professor at George Mason University School of Law and senior scholar at the University’s Mercatus Center. Durkin is a retired senior economist at the Federal Reserve Board. This is adapted from their recent book, “Consumer Credit and the American Economy,” co-authored with Gregory Elliehausen and Michael E. Staten.