Wednesday, October 9, 2013

Credit Card Debt and the Liquidity Trap

TournamentPlayersClub Sawgrass17thHole.jpg
Golf Course Water Trap - Wikipedia Commons

I'm not much of a golfer, so I know when I come upon a water obstacle, I can say goodbye to my golf ball.

No one made me go to the golf course, and the water hazard was clearly visible. I have no one but myself to blame for transferring ownership of my golf ball to the golf pond.

Like golf courses, credit card companies also have some tricks up their sleeve. Their version of the water obtacle is what I like to call, "the liquidity trap."

The Credit Card Liquidity Trap

The "liquidity trap" occurs because we can charge more each month than we are paying in service on the debt. Even when making payments on credit cards, the debt can be cash flow positive to us and continue to accumulate.

In a sense, the monthly payments are just a shell game as debt can continue to grow and draw us in - until it's too late.
For example, let's say we have a credit card with a $10,000 limit. Say the interest rate is 15%, it doesn't really matter (a red flag). We'll say the balance is $3,000, and the minimum payment $100 per month.
So if we make a payment of $100, and charge $300, there's net positive cash flow of $200. We also just went $200 more into debt. Debt that will from then on acumulate compounded interest.

Our Credit Rating Remains High While Being Drawn In

Meanwhile, since regular payments are being made on the credit cards, our Credit Rating remains high or even increases.

Society, through the Credit Rating system, is kind enough to pat us on the back as we rack up more and more unsecured obligations. We may have loads of debt, but our Credit Rating tells us we are good people - and from the lender's perspective we are.

So rather than feeling burden from the growing debt, we receive positive cash flow. And we can tell ourselves we're good lendees, as we're making our designated payments on time.
All seems well with our financial world.

Stein's Law

Herbert Stein is famous for his observation - dubbed Stein's Law - that if something cannot go on forever, it will eventually stop.
Credit card debt cannot go on forever (unless you happen to be the Federal Government), and what will one day happen is all available credit gets maxed out.
At this point, everything hits a wall. Because once there is no new credit - and only the sea anchor of existing debt - the cash flow must go negative.

Then we see the liquidity trap for what it truly is, a system for gradually drawing us into onerous debt. 

Sort of like when the golf course pond dries out, and we see thousands of golf balls lying at the bottom. All those golfers fell for the trap. But at least they could see it first, and they don't have to pay compound interest on lost golf balls.


Avoiding the Liquidity Trap

The liquidity trap is by design built into the very structure of the credit card concept.
Credit cards should require payment of the full balance at the end of each month. But what would that do to the credit card business? And to other retail businesses that depend on easy credit?
Some consumers try to avoid the liquidity trap by paying off their credit card balance in full each month. However, that's a risky strategy. Sort of like hitting that golf ball over the water obstacle is risky.

It's too easy to get drawn into to letting the balance acumulate, especially when difficult times come, and they will.
The only way I know to avoid the Liquidity Trap is to avoid credit cards. Hey, there's an idea - avoid credit cards and you'll avoid the liquidity trap.