Stock and flow

I’ve already made it very

clear what I think about credit cards: this post is an attempt to flesh

out one theory of how and why they work the way they do – to the benefit

of banks and the detriment of consumers. On the one hand it’s all blindingly

obvious, but on the other it’s not something I’ve really seen spelled out in

quite this way, so I thought I’d take a crack at it.

Most people, if you ask them what their highest-value asset is, might point

to their car, or their heavily-mortgaged house, or something like that. In fact,

their highest-value asset is much more likely to be their job: the present value

of their future income is enormous, and almost certainly worth more than their

home even without a mortgage. But although people don’t really think that way,

they do understand it on a gut level, just as they understand asset-liability

mismatches on a gut level.

What I’m talking about here is the difference between stock and flow, and the

way in which credit card companies take advantage of that difference to make

enormous profits. In financial markets, of course, there’s always someone willing

to convert stock to flow or flow to stock: any given income stream is worth,

today, a certain fixed amount of money. If I have a stock of money, I can convert

it into an income stream by buying bonds, and if I have an income stream there’s

bound to be someone I can sell it to for a fixed amount.

When it comes to personal finance, however, the equivalence breaks down. You

can’t monetize the present value of your future income: I can’t go to some broker

and tell him he can have 10% of all my future earnings in return for an upfront

payment of, say, twice my annual income.

As a result, unable to switch at will between stock and flow, people like to

match their assets to their liabilities. If their main asset is a flow –

their income – then their liabilities should be flow liabilities too.

Why did so many people feel uncomfortable about privatization? Because it took

a stock asset (a national company), sold it, and then applied the proceeds to

flow liabilities – the general fiscal account. It was called "selling

off the family silver" to pay day-to-day expenses: an asset-liability mismatch.

The general idea is that flow liabilities – the monthly bills –

should only be paid with flow assets – monthly income. Selling off assets

to pay the bills is unsustainable.

The genius of credit cards is that they slowly and invidiously turn flow liabilities

into stock liabilities. A credit card is a wonderful way of paying for something

today if you’re not going to get paid until tomorrow. So long as you pay off

your debt at the end of the month, it’s an interest-free loan: free money. It

feels like flow debt rather than stock debt: you use your income over the course

of the month to pay for your purchases over the course of the month.

Credit-card debts increase in small increments: a purchase here, a purchase

there, a finance charge at the bottom of the statement. Any individual purchase

can be justified. Here’s a thought experiment: tell someone that he has a credit

card with a $5,000 credit limit, and let him make purchases until the credit

limit is reached. There’s a good chance he’ll do so, even if the interest rate

on the card is over 20%. Now, take that same person, and offer him a $5,000

loan, unsecured, at an interest rate of 10%, which he can then spend on whatever

he likes. There’s a good chance he’ll refuse, even though going that route would

save him money in the long term compared to going down the credit-card route.

That’s because the second choice is stock debt, and people don’t like stock

debt because they don’t have stock assets. The first choice is flow debt, and

that’s fine, because people do have flow assets – their income.

What’s more, people always underestimate their future expenditures. They’ll

buy something now, justifying it with the idea that they’ll spend less next

month – something they rarely do. Most people who max out their credit

cards don’t intend to max out their credit cards. It just happens, almost while

they’re not watching. That’s another reason why our thought-experiment guy will

refuse the $5,000 loan: even if he understands that it would work out cheaper

than a $5,000 credit-card balance, he doesn’t think he’d ever max out a $5,000

credit card. A loan carries debt service whether it’s spent or not, so in fact

it’s rational to take the credit card rather than the loan if you think you

won’t carry much of a balance on it.

But anyone who’s ever got a credit card bill, whether they’ve paid it off in

full or not, has suffered a certain amount of cognitive disconnect between the

large number at the bottom of the bill and the seemingly small numbers which

constitute it. How could a series of individually small transactions add up

to such a huge amount? When you’re out there spending, it really doesn’t seem

that big. But when the bill arrives, suddenly those flow transactions –

day-to-day monthly expenses – have been transmogrified into a whopping

great big stock of debt.

That’s why, individuals would be much better off if they took out loans to

pay their expenses than if they borrowed on their credit cards. (They’d be better

off still living within their means, of course.) But loans are large, up-front,

stock transactions. They can be justified in exceptional cases, such as buying

a house or a car, or starting up a business. But people won’t take out a loan

to pay a restaurant bill, because they’ll be paying off the loan long after

the asset they’ve bought with it has been literally flushed down the toilet.

What’s more, any fool can see that if you need to take out a loan to pay a

restaurant bill, you shouldn’t be eating at that restaurant. Increasing your

stock of debt for the sake of a flow transaction like eating out is a classic

asset-liability mismatch. And yet people pay for their meals on their credit

cards the whole time, and, as often as not, fail to pay those credit cards off

in full every month. To all intents and purposes, they’ve borrowed the money

for the meal, and they’re paying interest on it at exorbitant rates.

Credit cards, then, are a wonderful way for banks to help consumers delude

themselves that they’re living within their means. Most people who carry a revolving

balance on their credit cards are simply spending more than they’re earning,

month in and month out. It’s unsustainable, but the existence of their credit

cards lets them get away with it for a much longer time than if they had to

justify their expenditures to their bank manager. The key hurdle becomes not

"can I pay my entire bill off in full at the end of each month", but

rather "can I pay the minimum amount at the end of each month". The

answer to the second question is nearly always yes – until you’re in a

hole of enormous magnitude.

Eventually, this entire edifice of credit-card debt could come crashing down

onto the banks, causing them as much harm as it’s presently causing consumers.

For the time being, however, they’re making billions from it. If that annoys

you, you can do your bit. Pay off all your credit cards with a loan –

one secured on your home, if necessary – and always pay them off in full

every month from here on in. Otherwise you’re just pissing your money away.

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7 Responses to Stock and flow

  1. 99 says:

    You are mostly spot on, but there is the issue of leverage exerted by the strange position some of us high-earner, low asset types, who don’t have many sources of capital (an affect of wage spikes in the 90’s but no family assets to speak of). I have currently about $90,000 in revolving credit available, most of it in the 5-9% range. I get a variety of offers (1.9% short term to 4.9% until the balance is paid) each month. As long as I keep a decent reserve (two-thirds, basically, giving me the flexibility to move quickly from one card to the other and not get penned in when an offer expires), I can get large sums of cash pretty cheap, perhaps even enough to justify regular trips to WD-50, anticipating that my earnings will outstrip inflation, and that I have a decent savings rate exclusive of this spend (or even perhaps in spite of).

    When I bought my car (I thought I was moving), the dealer was offering 7.9% (because it was an in demand model, there was little need for incentives). Chase, my bank, offered me a 5.9% five year loan, the very same month they sent me a 1.9% balance transfer offer for a credit card. The purchase price of the car was $25,000 and change. I used to purchase checks (no transaction fees). I paid the car off in about 24 months, and figure that I paid about net $800 in interest over that time. That’s about 3.15%, below prime at the time.

  2. Felix says:

    99, where prime is at is utterly irrelevant — the only germane reference point for you should be the rate of return you’re getting on your savings. Take that car: how much did $25,000 of savings turn into over the course of that 24 months? If it was less than $25,800, then you would have been better off paying cash for the car rather than borrowing at sub-prime rates.

    But the attractive initial offers on credit cards are attractive — that’s why they’re so popular. The question is why you need to be borrowing money at all, if you’re a “high-earner”. I also fail to see what real earnings have to do with anything. The question isn’t whether your earnings will outstrip inflation: the question is whether your earnings will rise faster than your expenditures. Unless and until they do, you will end up spending more and more money on finance charges, and going deeper and deeper in debt. My point about self-delusion had this situation in mind: people think that they’ll keep on spending the same amount of money they do at present, even as their income rises. They fail to notice that every time their income has risen in the past, their expenditure has risen as well. They never learn.

  3. Feli says:

    Oh, and if you didn’t have $25,000 in savings available to buy that car, then you don’t have a decent savings rate, you don’t have savings at all. If you have a total balance of $30,000 on your cards, then in order for your net savings to be positive, you need savings of more than $30,000. Obvs.

  4. 99 says:

    My savings rate is about 8-10%, which goes entirely into a tax deferred (SEP IRA) account (best deal I can get because I don’t have a mortgage deduction available). I can borrow against that, but the rates are horrendous, certainly not 3%. I don’t know if a SEP IRA counts as ‘savings’ in a traditional model (since the assets isn’t available for use once it is set aside), but there is the practical matter that in order to be ‘saving’ at a rate where your model is viable, I would need to be setting aside about 25% of my gross income monthly (and it would still about eight years before I had enough money to buy where I rent currently)

    High earner is relative. I scrape the low six figures on a average year, and with an upside of about a third more in a good year. I have some fixed costs that obviate making any real traction towards savings (obligations to my parent’s medical care take about a grand a month of the top — a pretax hit that I can’t write off, and then the decision to refinance their badly managed debt, which where my credit card balance came from, adds about another grand in debt service, because, in the end, I agree with you).

    You can argue that I should have set aside the $25,000 for two years, but obviously I didn’t have the cash. So for 3% interest, and a total cost over asset value of $800, I had full use of the asset for two years that I would not have otherwise. Allowing for price increases in the asset, and the swing (since I would be growing that capital) from the $600 or so I might have gotten from a Money Market, the total cost over and above the asset itself was maybe $1000. Which I could make over the weekend doing freelance.

    I know it must chap your hide that I just didn’t drop $25K in something like , but even as I save in real dollars more than 90% of the population in a given year (and earn the top quartile), I could not practically come by that kind of cash without living more or less in penury for about two years. That’s because of an extraordinary obligation (elder care, which in some months consumes more income that some of my peers make) that some of my peers don’t face currently, but it is a growing issue.

    My rent costs, as a percentage of income, dropped steadily from 1993 until this year. I had a good five-year trend line of discretionary (food & entertainment) spending descreases until this year. As my credit expanded and my income rose, my spending did not. It did last year, but I think it was a forthright decision, not some creep because I got a new credit card or a big check.

    I’m not disagreeing with you on how pernicious credit cards are, and you are right on the spending habits of most. But for those of us who don’t have any family or social network (every person I know in this city who bought an apartment relied on family for down payment) that provides capital, and have few liquid assets (imagine my chagrin when I applied for a mortgage for my parents and found out that my retirement savings was a eligble asset, but my car — far more liquid — was not), that someone gives me an unsecured line of credit of almost $100,000 at an average rate of about 4%, well, are you saying I should pass that up? (and I’m not saying I should take it all and go to Vegas). That’s phenomnally bad business, and retreats into the usual pap one hears from someone of means about the practical benefits of saving and horrors of debt, mostly because you presume an individual can’t make a calculated risk about debt and potential income in the same way a business owner can. Or maybe you should just say the poor are fat and stupid. They in large part are, so it wouldn’t be entirely prejudicial. And those of us who escaped that trap, well, at least we would understand better where you are coming from.

  5. michelle says:

    Oh my god! You used a z in privatization. Welcome to America, finally!

  6. Felix says:

    99, sorry about the delay in responding — I was out of town. Anyway…

    SEP IRA contributions are a Good Thing, but they’re not “rainy day” savings. Basically, you have no liquid cash assets, and tens of thousands of dollars in debts. At the moment, due to adroit card-juggling, those debts are carrying low rates of interest. You can’t assume that state of affairs will continue indefinitely, however, so it makes sense to try to pay down those debts while they’re still cheap.

    You write that “in order to be ‘saving’ at a rate where your model is viable, I would need to be setting aside about 25% of my gross income monthly”. My model? What model would that be? I don’t think I ever prescribed a savings rate, and I certainly never mentioned buying property.

    That said, you say you’re spending about $2,000 a month in, for lack of a better phrase, parental obligations. That kind of outlay obviously does make it more difficult to save money. But I do hope that when you say “debt service” you mean interest and principal repayments on your parents’ debt, and not just interest repayments. Cos if it’s the latter, what’s your plan for paying off the principal?

    As for the car, what you did made sense given that you do not have any liquid assets. I thought when you mentioned your savings, before, that they were more liquid than a retirement account which you can’t tap until you’re in your 60s, at least not without taking a large tax hit.

    Certainly given your risk and debt profile I wouldn’t recommend investing in risky stocks unless and until you’ve made a LOT of progress in paying off your debts. First things first. In fact, I repeat that in general I don’t recommend investing in anything before paying off credit cards. That should pretty much always be priority number one.

    In general, you simply have to remember why the credit card companies are offering you those 4% rates. It’s not because they make any profit there: it’s because those are introductory rates, and then the interest rate shoots up to something closer to 17% or a lot more after a certain number of months. That day can be put off for a while by moving balances around from card to card — and I commend you for playing the juggling game as well as you have for as long as you have. But the game will come to an end, and you need to have a game plan for what happens when the special introductory offers stop coming through your mailbox.

  7. 99 says:

    It seems are generally in agreement — the only place I know I’m delinquent is not having a money market account. My income (like yours, I believe) is Schedule C, so I make quarterly payments, and my immediate liquidity in some months is nearly 75% of my outstanding debt, but since much of that is offset by an outstanding tax liability, investing it for 60 days in stocks isn’t quite worth the risk. Also, figure the car is roughly the of the same value — since it is purely a convienence, I think of it as more liquid than most who need one for daily transport. I could sell it were the interest rates on all my card skyrocket simultaneously; mind that I carry at least two cards with a zero balance that could take 100% of my current CC debt. Otherwise, I would feel like I was treading far closer to the spiral you describe (and yes, I am paying down about 8% of principal each month — I traded in my mother’s 24.99% $15,000 balance for 2.9%. It took me two years to convince her it was financially prudent).

    The question is, that say I do set aside a small amount of savings while paying down the CC. After about 15 months, I’ll still be stuck with no assets, and if I want to make any large purchases, the most available leverage I’ll find is in my credit cards. And I hardly feel like my strategy is worse than the last year that resulted in larger principal debt.

    Given all this, I keep an average of ten grand in cash, and that absolutely should be in a money market. Perhaps all this hair-splitting force me to get off my ass.

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