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I'm reading Ray Dalio's How the Economic Machine Works, and although I understand the role of credit in an economy, I don't understand whether credit actually adds any value to an economy.

Ray says that credit is what causes economic cycles (i.e. people borrow and invest when interest rates are low, and save when interest rates are high). This behavior leads to short term debt cycles in the economy.

However, Ray also says that these short-term cycles are centered around a long term productivity growth of around 2%.

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So my question is as follows: If productivity will always grow at around 2%, what is the point of credit? Aren't you simply borrowing from the future, and then subsequently paying off those debts? Would economic growth be the same without credit? Would the economy be as efficient?

Thanks

Edit: Here's the paragraph that I'm confused about. Is this paragraph saying that credit doesn't add anything to an economy (since long-term productivity growth is the same regardless?)

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  • $\begingroup$ There is no reason to believe productivity must always grow at around 2%. It may have done on average during 1950-2000 but that is a particular interval $\endgroup$
    – Henry
    Jul 8, 2018 at 22:02
  • $\begingroup$ Doesn't really address my question: The 2% was just an example. My point is, if productivity growth is going to be similar in the long run, and credit just leads to short term fluctuations around the long-term productivity growth line. What is the point of credit? $\endgroup$
    – bugsyb
    Jul 8, 2018 at 22:04
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    $\begingroup$ I am challenging your suggestion that productivity growth is going to be similar in the long run. What happened in the 20th century was the result of a lot of things including wars and changes to credit $\endgroup$
    – Henry
    Jul 8, 2018 at 22:15
  • $\begingroup$ My question is: why is credit important to an economy? $\endgroup$
    – bugsyb
    Jul 8, 2018 at 22:17

1 Answer 1

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Credit or more broadly finance helps to allocate scarce resources to where they are most needed.

Example. Suppose party A is sitting on a pile of resources from which he thinks he can make a return of 1% (per annum). Party B has no resources, but thinks she can use party A's resources to make a return of 3%. Then both parties can benefit if A loans his resources to B at a rate of 2%. (Society also benefits, at least insofar as the economic pie is larger than it would otherwise have been.)

(Of course, in the real world, A and B may be very much mistaken about their rates of return, which is partly how bad things like financial crises arise. But the above simplistic example illustrates what's "supposed" to happen, at least in a world of perfect information.)

P.S. Your presumption that "productivity will always grow at around 2%" is false. Finance/credit is at least part of the reason for non-trivial economic growth in the past 250 years. In a world where entrepreneurs are unable to gain credit, economic growth would be lower.

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