Thursday, September 18, 2008

Forward into the Past: October 1929, Part 5 of 6

According to Charles Kindleberger, quoted in Tuesday's Wall Street Journal ("Review & Outlook: Surviving the Panic," WSJ, 09/16/08, A24), "financial manias throughout history have shared one trait: the excessive expansion of credit." This is correct as far as it goes. The problem is that it doesn't go far enough. We need to amend it to read, "the excessive expansion of the wrong kind of credit . . . for the wrong reasons."

There is nothing wrong with credit extended for financially feasible projects, that is, for the purpose of capital formation, "capital" being (in this context) something that pays for itself out of its own earnings. By definition, "financially feasible projects" are self-justifying or self-liquidating investments that are expected to produce marketable goods and services and pay the cost of the investments out of the earnings of capital. Extension of credit for productive purposes was, as Dr. Harold G. Moulton of the Brookings Institution pointed out in his 1935 classic, The Formation of Capital, how the United States financed the explosive growth it experienced between 1830 and 1930.

Examining financial panics throughout history, whether Holland's Tulip Mania, John Law's Mississippi Scheme, the South Sea Bubble, the Panics of 1819, 1837, 1873, 1893, and 1907, the Florida land rush, the Crash of 1929, or the current sub-prime mortgage debacle, we find that in each and every case the bubble resulted from diversion of credit away from productive purposes and, often, into non-productive, speculative ventures.

Subsequent drying up of credit for productive purposes — capital formation — plunged the affected economies into recessions and depressions, from which in some cases the economies took decades to recover . . . just in time for the next round of speculative frenzy as people eschewed hard work and sound credit for capital formation in a quest for the fast dollar financed with other people's money. The perverse insistence on expanding bank credit to finance speculation, government debt, unsustainable home mortgages, and consumer credit, while leaving industry, commerce, and agriculture to seek financing out of existing savings or do without, has crippled economic growth ever since the beginnings of central banking in the 15th century.

The problem is not that credit is bad, but that the wrong kind of credit is bad, as Aristotle pointed out twenty-five centuries ago. Lending or creating money for something that does not generate income to repay the loan and charging interest is called "usury." Pagans, Jews, Christians, and Muslims have condemned usury from the dawn of recorded history. Lending or creating money for something that generates income to repay itself is not, however, usury, and is even in some circumstances considered the eighth or highest form of charity.

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