“Creditworthiness is like virginity, it can be preserved but not restored very easily, so it is crazy to play around with it.”
Warren Buffett
Our society has different views on debt. Some people think it’s bad, while others use it for their benefit. For years I believed that debt was a terrible thing, and I never wanted to get a credit card. I thought we should all avoid debt at any cost. That changed when I started to educate myself on financial literacy and realised that the reality is quite the opposite, since the whole economy runs on debt.
I checked my credit score, and found it was very low. That wasn’t because I’d been bankrupted—it was because I’d never been in debt, so I didn’t have any credit history. Ironically, you need to be in debt to improve your credit score. More accurately, you need to get into debt and then have a good track record of paying it back.
To understand the logic behind this, it’s worth learning about where the concept of money itself came from and the idea of trust that underpins it.
A short history of money
The economy of early civilisations was mainly based on the barter system, which meant exchanging physical goods for manual labour. Exchanging something useful for something that met a similar basic need made sense at that time. Still, the barter system had a few problems which held back economic growth.
As an example, imagine you plan to exchange grain for a new pair of shoes from a cobbler, but the cobbler already has enough grain stacked up in his house. There’s obviously less chance that the transaction will go ahead. To get your shoes, you basically have to offer something that the cobbler needs. Maybe his workbench needs resurfacing or his wobbly chair needs a new leg, or perhaps he just needs a haircut. Whatever, the chances are that you won’t be able to offer any of these things unless you’re a trained carpenter or a barber.
In the barter system, neither your dream of getting a shiny new pair of shoes nor the problem of getting rid of your excess grain will be fulfilled. What’s more, the cobbler has fewer chances of being able to upgrade either his workplace or his appearance.
This kind of limitation made economic transactions difficult. The size of the economy also limited the number of physical goods and services that were available to go around. This led to the stagnation of the early economy.
The only means of economic expansion in this system was invading neighbouring territories to capture more food, water, farmland and slaves, which was common practice back then. Unfortunately, constant war was not only unsustainable but also a very risky proposition, since the price of failure was having your head chopped off. As a result, people soon started exchanging goods and services for something valuable and trusted, such as gold and silver.
The economy as we know it today is largely based on currency, or money as the form of exchanging value for goods and services. In the early days of currency, coins had the value of the metal they were made from, such as gold and silver. Coins also had the seal of the king, which made them legal and trusted.
After this, countries began producing paper notes, which don’t have the value of the material they’re made from. For a long time, the amount of money that a country could produce was equivalent to the amount of gold reserves a country held. This was called the gold standard. But gold reserves were limited, and governments eventually became frustrated. The US mostly abandoned the gold standard in 1933, and stopped using it altogether in 1973.
Today’s monetary system is called a fiat system. Nowadays coins are made of cheap metals and notes are made of recycled fibres. The fiat system removes the restrictions countries experience with the scarcity of gold. Gold has now been replaced by ‘trust’ in the governing body. That body is the Federal Reserve in the US, and central banks in other countries.
Why money works: the importance of trust
How does money whose value isn’t pegged to any valuable material survive? The answer is simple: trust.
We trust that the paper currency we use is genuine and issued by a trusted authority, and will be accepted as a means of exchange for goods and services. On the other hand, if banknotes are counterfeited or people stop accepting them for some reason, they will lose value immediately. The same happens to digital currency: it loses its value if the source of the currency isn’t genuine or trusted.
The value of a country’s currency also reflects the amount of trust in that country’s economy. Corruption or social or political unrest in a country causes a decrease in the country’s currency value. Conversely, when a government is stable and the governing body is transparent and trusted, demand for the currency increases and so its value rises.
The key thing to note here is that the importance of trust is not just limited to central banks, but extends to anyone who takes care of money. People don’t deposit their money in places they don’t trust. Equally, they don’t lend money to people they don’t trust. You only lend someone money if you trust them to pay it back on time. Since the very early ages of human civilisation, people have lent and borrowed money and goods based on this simple notion of trust.
Nowadays this trustworthiness is called credit.
How credit fuels the economy
A large part of today’s economy is based on credit. It’s the lifeblood of economic growth, and actually the tool that the modern economy uses to create money out of thin air.
Banks lend money to the government, businesses and individuals so that they produce more goods and services. But this money isn’t money they actually own in a physical form. They lend money as credit to an institution or individual that they trust will be able to pay it back, with interest.
The 2008 economic crisis, also known as the ‘credit crunch’, is an excellent example of how much our economy is based on credit. Lehman Brothers, a US financial services company, was the fourth largest investment bank in the US, and heavily backed by the subprime mortgage market. When real estate prices fell in 2007-8, the company was in trouble. They couldn’t pay back their creditors and so their share price fell. Billions of dollars worth of equity was withdrawn from their portfolios, which triggered a domino effect across the US economy. Investors started pulling out money, sparking a massive sell-off worldwide.
Although the root cause of the crisis was a price correction in the housing market, the broader economic fallout was fuelled by uncertainty in other industries. Investors and creditors worried about not being able to get their money back. Simply put, a lack of trust sent major world economies into a downturn. Then its ripple effect put developing economies into an even more difficult position.
New cities, skyscrapers, railway links connecting continents, aircraft and spaceships are symbols of the world’s economic growth. Most of these projects are financed—in other words, they’re built using money that doesn’t exist. Creditors lend money to these projects based on the belief that their capital will be paid back with interest. Those creditors, in turn, may have borrowed that money from somebody else who trusted them.
This elastic nature of the global credit system has unlocked unimaginable growth and expansion opportunities for the world economy. Yet key to its survival is the ability to pay back debt. Entities ranging from organisations to entire countries all have a credit rating based on their ability to pay back debt. Even micro players like you and me, who are part of the social and economic ecosystem, are given a credit score to indicate how trustworthy we are when it comes to debt repayment.
Why debt can be good
There are two kinds of debt: good debt and bad debt. If you use finance to build a business or acquire an asset—such as buying a property as an investment—that’s good debt. Because business or rented property will generate an income, their value will go up. On the other hand, if you use finance to purchase a liability such as an expensive car, this is considered bad debt since your car will not generate income. Its value will decrease over time, and it will also incur an ongoing maintenance cost.
For sure, not being in debt can give you peace of mind, and I agree that peace of mind is supposed to be one of the objectives of achieving financial freedom. However, given the role of debt in the modern economy you won’t be able to avoid it entirely. I can even say that you’ll have to be in debt in one way or another if you want to run a business. Debt is a powerful tool if used correctly, for example as leverage to get your business off the ground faster. At the same time, you obviously need to make sure you don’t place yourself at risk by over-borrowing.
When you keep up with debt repayments, your credit score starts to build up. Other factors influence your credit score too, but the main thing is your track record for paying back debt. A credit score gives a lender some idea of how trustworthy, responsible and reliable you are, so the more money you pay back on time, the more chance you have of getting more finance with better terms in the future.
Why trust matters (again)
Trust—in the form of your credit score—is key to successful financial growth, but the idea of trustworthiness doesn’t have to stop there.
If you’re aiming for financial freedom, it can help to build up your trustworthiness in all aspects of your life. You can do this by putting service at the heart of your business. Think about how you can provide the best quality product or service to your customers before thinking about profit. Of course you need to make some profit in order to make your business sustainable, but you get the idea.
In today’s vastly over-saturated economy, it’s easier than ever to buy cheap products and services online. Quality goods and producers who provide top quality service are still just a handful. Be honest and trustworthy for your customers: they can sense when you’re trying to give the best possible service, and will remember you for it. As a result, businesses and individuals who provide honest, quality service are best placed to build up a long-term, loyal customer base.
In summary, I recommend trying to build up your credit score—and thus your trustworthiness—for your business partners and lenders. Extend your trustworthiness to other aspects of your personal life too and in return, your personal and financial life will have the best chance of success.