Tuesday, December 21, 2010

What Is, What You Think Is, and What Should Be

We love our correspondents. Okay, some of them — those that ask intelligent questions . . . which, frankly, covers a very broad range. As they/we say in Mensa, the only dumb question is the one you don't ask. That, of course, applies to real questions, not disguised lectures, equivocations, attempts to trip people up, so on, so forth — you know, what passes for "honest debate" in much of academia and is neither honest nor debate.

Be that as it may, yesterday's correspondent sent us a follow-up question that came out of yesterday's lecture on distributism:

A key question for me is this: Although banks do this badly (and now almost not at all) do they not lend money on the soundness of a project, re: discounting the future income streams? This seems to be one crux of the issue. So at least for the moment, its not that this part of the system (bank lending on future earnings) doesn't exist, but that its not done very well by the system.
Looking back on my answer, I think I might not have answered it completely, but that's the beauty of using correspondence as the basis for a blog posting — you get a chance to edit, amend, and expand on possibly doubtful areas . . . or (as in this case) actually get around to answering the question, that is, do banks lend based on the present value of the anticipated future income stream?

The quick and easy answer is, absolutely. A loan officer reviews the loan applications and (presumably) checks out the assumptions very carefully, verifies the collateral, the prospective borrower's character ("all loans are 'character loans'" is an old financial aphorism), and so on. He or she then signs off on the loan, and hands over the cash, up to the value of the discounted cash flow or the collateral, usually whichever is less.

This method of estimating the present (and thus loanable) value of a project causes massive confusion among non-finance people. The discounted cash flow method is only an estimate of the actual amount that the borrower anticipates receiving from the project, and (if he or she is being smart) is a big underestimate of what the borrower really expects to receive. He or she is also supremely cautious about the discount rate chosen, as well as all other assumptions.

As a rule of thumb, a borrower should be extremely pessimistic when borrowing, and extremely optimistic when putting the capital into production to pay off the loan as fast as possible. The bottom line is that borrowers usually try to get something at the lowest possible cost, but then work it to its optimal capacity to speed up the payback and get out from under the loan. All these things are estimates, anyway, and the success of a project usually depends on how well the borrower and the loan officer made their estimates, and how closely they manage to adhere to their projections — one of the reasons why some business folk tend to think of the budget as a god instead of as a useful tool.

The problem is that this is how banks are supposed to be making loans, and how they are designed to operate, more or less. Unfortunately, even some bankers don't understand the process, and assume as a given that the true feasibility of a project depends not on whether the assumptions used in arriving at a project's net present value are good, but on whether there are sufficient accumulated savings in the bank to lend for that project.

The key to understanding this rather odd situation is to realize that how the experts tell us a bank operates is not exactly how a bank operates. One of the first things I learned as an auditor is that there is the way the system is supposed to work, the way the people involved think it works, and, finally, the way it actually works. The task is to bring all of these together into material conformity with one another so that the financial statements accurately reflect the position of the accounting entity. This is not the case with the United States and the manipulation of statistics and incomplete reporting that's going on.

Moulton goes into this when examining the Keynesian "multiplier effect" on pages 77-80 (and in detail, 80-84) in The Formation of Capital. The experts invariably define a "bank" as a financial institution that takes deposits and makes loans. This is the definition of a "bank of deposit," e.g., a credit union, savings and loan, or investment bank, which cannot make a loan until and unless the funds already exist as part of the bank's capitalization or have been put on deposit.

There is, however, another — and older — type of bank, the "bank of issue," of which the most common type today is the commercial or mercantile bank. A bank of issue is defined as a financial institution that takes deposits, makes loans . . . and issues promissory notes, usually in exchange for bills of exchange drawn by individuals or companies representing the present value of existing and future marketable goods and services.

Per the real bills doctrine, a commercial bank can create money backed by discounted bills of exchange up to a multiple of its reserves, the multiple being the reciprocal of the reserve requirement. Thus, a 20% reserve requirement would mean that a bank with $1 million in reserves can create money by discounting or rediscounting bills of exchange up to $5 million.

Keynesian economics (and Monetarist/Chicago and Austrian) rejects or changes Say's Law of Markets, and thereby rejects its application in the real bills doctrine. According to Keynesian multiplier theory developed by Richard Kahn in the 1930s when Say's Law was under attack by Keynes, a commercial bank can create money as described above, but it doesn't. In Keynesian theory, backing the money supply with private sector hard assets in the form of new capital is considered much too risky, compared with backing the money supply with government debt based on a deteriorating economic situation and declining tax base.

Instead, the theory is that someone deposits cash in the bank, thereby increasing the supply of loanable funds. Given a 20% reserve requirement, the bank immediately loans out 80% by means of a check, which is deposited in another bank, which then lends out 80% of the 80%, and so on, until the money supply has been increased by a factor determined by the reciprocal of the reserve requirement.

Unfortunately, while the math "works," the theory doesn't hold water. Baron Kahn forgot one gigantic fact that occurred to Moulton immediately. That is, checks do not remain on deposit.  Checks are presented for payment to the banks on which they are drawn.  This results in a transfer of reserves between banks. Further, a check, while a negotiable instrument (actually a form of bill of exchange), does not qualify as reserves.  Thus, even if checks remained on deposit without ever being presented for payment (which is not the case), the money supply would not increase one cent (or one penny), because a bank cannot make loans out of checks on deposit. As Moulton pointed out, there is a constant shifting of the reserves as checks clear, but the amount of money in the system does not and cannot increase in the way Kahn theorized — even though it is the standard explanation in all the textbooks.

Nevertheless, federal government monetary and fiscal policy is set as if the multiplier effect were valid and not a Keynesian fantasy, based on the wrong definition of money, and a partial definition of a bank. This is "a bad thing," because commercial banks have the power to "create money" (more accurately, transform the money created by the drawer of a bill of exchange by changing it into a more convenient or acceptable form) by discounting and rediscounting bills of exchange, and issuing promissory notes that either back new demand deposits on which the "borrower" can draw checks, or (very rare today) banknotes that then circulate in the community as a medium of exchange — hence an archaic term for a bank of issue: a "bank of circulation."

Nor is a bank strictly necessary to issue bills of exchange and use them to settle debts. In fact, a rough calculation for 2008 reveals that approximately 60% of the transactions in U.S. GDP were carried out by means of privately issued bills of exchange that circulated among businesses domestically and abroad, being discounted and rediscounted among businesses and individuals until being presented for payment on maturity. Called "merchants acceptances," these formerly made up the bulk of the money supply before government got so big. Congressman George Tucker in the late 1830s estimated that merchants and bankers acceptances constituted more than 95% of the U.S. money supply.

Money circulated in the form of privately issued bills of exchange for thousands of years before the invention of coined money.  This is evident from the numerous clay tablets from Mesopotamia and papyri from Egypt.  A large proportion of these are in the form of negotiable contracts: bills of exchange, promissory notes, drafts, and so on, the latter being derivatives of bills of exchange.

It is still possible, given an individual's or business's creditworthiness, to carry on transactions by means of privately issued bills of exchange, and quite a large amount of business is still carried on this way, "B2B." Most small businesses, however, don't have the "name" or credit rating to carry it off. Further, the public doesn't generally accept bills of exchange in daily transactions — just promissory notes backed by government "anticipation notes," i.e., debt to be redeemed (maybe) out of future tax collections.

The main problem right now with the banks seems to be lack of sound collateral. It may not be conscious, but banks are very leery right now of traditional forms of collateral, i.e., corporate equity in the form of retained earnings, or some derivative thereof. The rapid gains in the stock market should make people a lot more suspicious and fearful than it evidently does — they forget that the stock market took a quarter of a century to recover after the 1929 Crash; rapid rises in share values are not a recovery, but suggest a speculative bubble getting ready to burst. Since share values are, at least in some measure, a way of determining the value of a company and thus its creditworthiness by the value of its equity/collateral, bankers would be fools to lend on the strength of a rapidly rising stock market in the middle of a depression — and bankers are not fools, or they wouldn't be in business.

Capital Homesteading would replace traditional collateral backed or represented by retained earnings and other corporate equity with capital credit insurance and reinsurance. In and of itself this would probably unclog the lending stream — just as it would have in 1929 after the fall in stock prices eroded existing collateral and forced many companies into bankruptcy when they couldn't get credit. Capital Homesteading then adds the expanded ownership aspect and a "few" other things, but the important thing for financing new capital in the aggregate is being able to get credit where it is needed in a way that does not endanger the borrower, concentrate ownership, or otherwise have a negative impact on the financial feasibility of the new capital and thus creditworthiness of the borrower.

This is why, in short, community banks and small businesses should be the strongest supporters of the push to enact a Capital Homestead Act by 2012 — although we wouldn't complain if it came sooner. So what if it's the 149th anniversary of Lincoln's 1862 Homestead Act instead of the 150th?

There are one or two things a small business can do right now to improve its creditworthiness and improve its chances of obtaining credit. For example, assuming a company that is otherwise doing pretty well, they might want to consider adopting a 100% S-Corp ESOP . . . which pays no federal or state corporate taxes. This effectively improves the bottom line by as much as 50%. We only recommend this if the company also implements Justice-Based Management due to the morale problems associated with calling people owners when they have no rights of owners, but that should not be a problem in a company that tries to adhere to the natural law principles found in Catholic as well as Jewish and Islamic social teaching.

Bottom line: there is a little (though clearly not enough) that can be done within the existing legal system to implement a quasi-Just Third Way approach, though of course not the Just Third Way in a systemic or meaningful way. That's one reason why we're watching a new prospect that has just developed so closely, as it might give us the political leverage to stage a demonstration, using an executive order from the president instead of legislation from Congress, and on the strength of the success of the project, get the enabling Capital Homestead legislation through.

#30#

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