That’s a frequent question—the answer lies within the important distinction between assets and liabilities. Money is a financial asset that one may spend—it represents an existing asset that may be used to purchase goods or services. When calculating the money supply, the Federal Reserve includes financial assets like currency and deposits. In contrast, credit card debts are liabilities. Each credit card transaction creates a new loan from the credit card issuer. Eventually the loan needs to be repaid with a financial asset—money. To households, the line of credit associated with a credit card is not a financial asset, only a convenient vehicle for borrowing to finance a purchase.
Money is an asset
Money is a financial asset, something that serves as a medium of exchange, acts as a standard of value that is generally acceptable for the purchases of goods and services or the repayment of debts, and serves as a unit of account. The Federal Reserve Board’s primary measures of the money supply consist mainly of currency plus financial assets on deposit with financial intermediaries and as assets held by households in money market mutual fund accounts.
The Federal Reserve’s two most popular monetary aggregates are M1 (the most liquid financial assets) and M2 (M1 plus other liquid financial assets.) A third measure of the money supply, M3, will be discontinued in 2006. M1 includes financial assets held by the non-bank public that may be used for transactions (mainly currency, demand deposits, and NOW accounts). As of October 2005, M1 was $1,362 billion on a seasonally adjusted basis. M2, which includes M1 plus consumer time and savings deposits, and retail money market mutual fund shares, was $6,629.5 billion. For a more complete definition of the components of the money supply and current money supply data, please see the Board’s weekly H.6 Release, Money Stock Measures and check out Ask Dr. Econ for April 2004.
A credit card transaction creates a liability
The use of credit, such as a credit card, is effectively the same as taking out a loan—that loan is a liability for the borrower. Samuelson and Nordhaus (2001) describe credit as, “…the use of someone else’s funds in exchange for a promise to repay (usually with interest) at a later date.”
Credit cards do provide a method of purchasing goods and services that is an alternative to using money. However, rather than purchasing goods with an existing financial asset—like the types of financial assets defined as money and included in the money supply statistics—credit card transactions create loans that the purchaser-borrower must later repay.
The category of consumer loans that includes credit card lending is called “revolving credit”; this measure was $801.4 billion on a seasonally adjusted basis as of October 2005. Additional detail on outstanding consumer credit is available from the Board’s monthly G.19 Release, Consumer Credit.
In recent years, as is shown in Chart 1, revolving credit outstanding at commercial banks has been surpassed as consumer borrowing has shifted towards loans backed by home equity lines of credit. In addition to rapid appreciation in home prices, creating home equity, home equity loans secured by housing equity have generally been priced well below rates on unsecured credit card debt.
Chart 1 -- Bank Home Equity Loans Now Exceed Credit Card Debt
What about debit cards?
In contrast to purchases with credit cards, debit card purchases transfer money electronically from individual and business bank accounts to the sellers’ accounts. Spending with a debit card would affect demand deposits and the money supply in the same way that purchases with a check or cash does. Because a debit card transfers your existing financial assets—the financial assets that you may access with a debit card are included in the money supply.
Importance?
Why is it important to distinguish between financial assets (like money) and liabilities (like credit card debt)? First, from an economic standpoint, the Fed measures the amount of money in the hands of the public because of its potential use as an indicator of monetary policy; the money supply measures reflect the different degrees of liquidity that different types of money have. See Ask Dr. Econ (January 2003) for some historical perspective on the use of the monetary aggregates.
The Fed monitors the amount of money in the economy and tracks the amount of existing consumer credit. While both the money supply and existing credit card debt may be important indicators of trends in the economy, financial assets (money) and liabilities (credit card debt) may not behave similarly over time. Chart 2 compares the relationship between the growth rates for the M2 monetary aggregate and for credit card loans (revolving credit) over the period from 1985 to 2005. Over the period, money and consumer credit growth rates often moved in opposite directions (one should be careful to remember that correlation (even when negative) does not necessarily imply causation!). The point is that different economic factors will affect growth rates of the money supply and of credit card debt.
Chart 2 – Growth Rates of Monetary Aggregate M2 and Credit Card Debt
From a personal finance perspective
Finally, the difference between money and credit also is important from a personal finance perspective. You shouldn’t view a $1,000 credit card limit the same way you would view $1,000 in cash. Spending today using a credit card loan means that at some point in the future you will have to reduce your spending in order to pay back that credit card balance and any accumulated interest!
References (as of April 2006)
Credit cards or cash? Credit cards offer convenience and a long list of benefits that cash doesn't provide, but they also represent an ever-present opportunity to fall into a cycle of revolving debt that can last years, decades or even a lifetime.
So how can you identify the best times to pull out cash or plastic for your next purchase? Here are a few guidelines.
When a transaction fee is involved. If you're thinking of paying your income taxes, mortgage, health insurance premium or other recurring bill with a credit card in order to potentially rack up reward points, miles or cash back, think again. Even if the servicer allows credit card payments (many don't), they'll typically charge a convenience fee that most likely outweighs the value of any reward. The IRS allows credit cards for tax payments, but with a 1.87% to 2.25% processor fee (in addition to the interest rate on the credit card if you don't pay your bill in full). In contrast, the IRS allows short-term payment extensions for no fee and installment plans for $52 to $120 (depending on the taxpayer's financial situation). Late payments are subject to a penalty (0.5% per month) and interest (the federal short-term rate plus 3%), but the total might be lower than the cost of using the credit card.
When you haven't yet negotiated with a creditor. Whether it's medical bills or some other expense that is unexpectedly large or out of control, before you charge up a credit card and trade one financial problem for another, contact the company's billing department. It might reduce the balance owed or offer a payment plan with terms that are far more advantageous than that of your credit card.
When you are in the process of obtaining a mortgage. Mortgage underwriters don't want to see any changes in your creditworthiness between the time you apply for a loan and the time it closes. If your credit card utilization suddenly goes up, your credit score could take a hit, leaving you unable to qualify for the loan that's on the table. Resist the urge to go shopping for things your new home needs. If you're in the mortgage process, use your credit cards very sparingly if at all.
When you want something you can't afford. It doesn't matter if it's a restaurant meal, a new outfit, the latest smartphone, a vacation you really think you deserve or the wedding you've dreamed of since childhood. Big or small, if you can't afford it, don't buy it. Don't let a credit card trick you into thinking you should have something when it is, in reality, not in your budget. Credit card credit lines can feel like an extension of your income but you need to realize that card spending constitutes a short term loan of the credit card company's money.
When you already carry a balance. If you have credit card debt, you can't afford to use your cards. Instead, pay down the balance before you add any new charges to the mix, or you risk getting stuck in a cycle of debt. And make sure you have the best card your credit score can get you. (For more, see "Signs You Need to Look for a Better Credit Card.")
To use as a convenience to purchase goods and services that you can afford. Credit cards are more convenient and secure compared to carrying cash. As long as you can pay your bill in full then a credit card is a logical and desirable alternative to cash for in-person purchases and a necessary tool for online transactions.
When you want additional warranty or purchase protection. A credit card can be a great way to protect a major purchase. Most card issuers offer purchase protection and an extended warranty for items bought with the card. Visa doubles the manufacturer's warranty, up to one year. MasterCard similarly doubles the warranty, offers 60 days of price protection and even insures the purchase against theft or damage for 90 days. (For both brands, benefits vary by card issuer.)
When you want stronger fraud liability limits. Credit and debit cards all limit cardholder liability in the event of fraud, but credit card protection is stronger. A credit card holder's liability for fraudulent use ranges from $0 (if the loss is reported before any fraudulent charges are made) to $50 (if the loss is reported after unauthorized use occurs). On a debit card, however, liability can be unlimited. It is $0 when the loss is reported before unauthorized charges are made, $50 if the fraud is reported within 2 business days, $500 if the fraud is reported more than 2 but less than 60 days after it occurs, and unlimited when the fraud is not reported until more than 60 days after it occurred.
To take advantage of benefits exclusive to the card. Co-branded credit cards typically offer exclusive benefits specific to the brand. For example, some airline credit cards offer free checked bags to people traveling on tickets purchased with the card. Likewise, some hotel chains offer upgrades or special amenities to guests who pay with a branded card. (For more, see "Should You Get A Gas Credit Card?")
To earn rewards. So many popular credit cards offer rewards programs, it's hard to think of a good reason to carry a credit card that doesn't. The programs are highly competitive: Some offer cash back on every purchase; others pay points. Consumers who qualify can earn hundreds, even thousands of dollars back each year on everyday household spending. (The American Express Blue Cash Preferred card pays 6% cash back on grocery store spending up to $6,000 per year, for a potential rebate of $360. Cardholders earn a smaller percentage back for other categories of spending.)
For security while traveling. People who travel can be more vulnerable to fraud simply by virtue of the unfamiliarity of the local language or surroundings. Lost or stolen cash is gone forever, but a credit card can be shut down and replaced during one phone call.
Avoid using a credit card unwisely. Debt is costly. Don't succumb to the temptation to spend beyond your means simply because a credit card with an available balance beckons from your wallet. Instead, focus on using it as a tool to get added value from your planned spending.
When you do use a credit card, do the math. Figure out if the benefit you seek is worth the cost you'll pay in fees and interest. For more information, see "Credit Card Savings."