Tuesday, January 4, 2011

Pure Credit for Student Loans

If you go to the "Binary Economics" entry in the Wikipedia, you'll find some statements regarding the use of "pure credit" — that is, credit extended without first cutting consumption and accumulating money savings — for student loans, State-owned infrastructure, e.g., roads, bridges, sewers, and so on. This is presented as fully consistent with the theory of Binary Economics. The justification is that Louis Kelso and other authorities sanctioned the use of pure credit for such purposes, and it is therefore sound theory. We disagree for two reasons. One is a matter of form, the other of substance.


First, as a matter of form, using the "appeal to authority" is a bad way to argue. The issue is whether the use of pure credit is consistent with the principles of Binary Economics, not whether Louis Kelso or anyone else claimed it is consistent or advocated it as an expedient. That is, do you present your case based on faith in the infallibility of the dicta of Louis Kelso or anyone else, or do you present your case based on a clear set of principles and a sound argument? As G. K. Chesterton quoted St. Thomas Aquinas when faced with a similar situation,

Behold our refutation of the error. It is not based on documents of faith, but on the reasons and statements of the philosophers themselves. If then anyone there be who, boastfully taking pride in his supposed wisdom, wishes to challenge what we have written, let him not do it in some corner nor before children who are powerless to decide on such difficult matters. Let him reply openly if he dare. He shall find me there confronting him, and not only my negligible self, but many another whose study is truth. We shall do battle with his errors or bring a cure to his ignorance. (St. Thomas Aquinas, quoted by G. K. Chesterton in The Dumb Ox (1933).)
As Chesterton went on to explain,
It is no good to tell an atheist that he is an atheist; or to charge a denier of immortality with the infamy of denying it; or to imagine that one can force an opponent to admit he is wrong, by proving that he is wrong on somebody else's principles, but not on his own. After the great example of St. Thomas, the principle stands, or ought always to have stood established; that we must either not argue with a man at all, or we must argue on his grounds and not ours. (Ibid., 95.)
Thus, it is not what Louis Kelso said about anything that makes it true or consistent with Binary Economics, but whether what Kelso said is consistent with the principles he himself laid out. Anyone can change his or her mind, or be provoked into an unthinking utterance ("What sluggish knaves are these of my kingdom! Is there not one that will rid me of this troublesome priest?"). While someone is, of course, responsible for what he or she says, that does not make it true or consistent with his or her previous position or stated principles. If the previous position is consistent with accepted principles, and the change of mind or heart is inconsistent with those same principles, reason dictates that we should go with whatever is consistent with the accepted principles, not accept an inconsistent development or give in to intellectual bullying.


The matter of substance relates to the basic principles of Binary Economics, e.g., whether it is consistent with the principles of Binary Economics to use pure credit financing for education. What follows, obviously, is "pure theory" and does not match current practices of the global financial system, which, frankly, is based on some very distorted notions of money, credit, banking, and finance.

There are two basic types of banks, "banks of deposit" and "banks of issue" (also once known as "banks of circulation"). A bank of deposit is legally defined as a financial institution that takes deposits and makes loans. A bank of issue is legally defined as a financial institution that takes deposits, makes loans, and issues promissory notes.

The most common types of banks of deposit today are credit unions, savings and loans, and investment banks. The most common type of bank of issue is the commercial or mercantile bank. A central bank is a special type of commercial bank, ideally restricted to serving (other) commercial banks as its customer base.

The chief business of the bank of deposit is to aggregate savings (either in the form of capitalization or deposits), and make loans. The chief business of a bank of issue is to discount and rediscount bills of exchange, that is, "purchase" bills of exchange by creating a promissory note, either directly in the form of small denomination banknotes, or in a large denomination to back a newly created demand deposit (checking accounts — "mini" bills of exchange).

To oversimplify, a bank of issue "buys" money in the form of privately issued bills of exchange. The bank then "retails" the money in the form of banknotes and demand deposits. It thereby breaks the "wholesale" bills of exchange, typically denominated in units of $100,000 or more, into smaller packages that can be used in daily transactions.

Massive confusion results from the fact that most commercial banks today also deal in deposit banking. Even more confusion results from the fact that the understanding of "bank" in the three mainstream schools of economics (Keynesian, Monetarist/Chicago, and Austrian) is limited to the bank of deposit. Binary Economics, however, recognizes the bank of issue.  In consequence, public policy does not, as a rule, recognize the bank of issue, nor use the commercial banking system or the central bank properly.


A student, or anyone else (such as a consumer as a consumer, or the State) who is not investing money in a productive and financially feasible project (i.e., an investment that generates income sufficient to repay the cost of the project and thereafter provides the owner with income) should use a bank of deposit. The capitalization and deposits of a bank of deposit, such as a credit union, all come out of existing accumulations of savings, that is, from having cut consumption in the past. Since, as Adam Smith pointed out in the opening passages of The Wealth of Nations (1776), the purpose of production is consumption, any loan for consumption should come out of existing accumulations of savings. Credit unions usually do this on favorable terms for their members, since they are "cooperative banks," presumably functioning in the best interests of their depositors, not outside shareholders.

Only borrowers who are obtaining financing for capital projects that will pay for themselves within a reasonable period of time should borrow from commercial banks. They are not really borrowing in any event, but availing themselves of the special function of a bank of issue to convert one form of money (a privately issued bill of exchange) into a more widely acceptable form of money (currency or demand deposit), a service for which the commercial bank properly charges a fee, the "discount," as well as a risk premium.

In essence, the commercial bank is permitting the borrower to use the bank's good name and assuming the risk that the bill of exchange will not be paid at maturity, thereby protecting holders in due course of the bank's promissory notes. This process is described in The Formation of Capital by Dr. Harold G. Moulton, president of the Brookings Institution from 1916 to 1952, as an alternative to the Keynesian New Deal.

As for credit cards connected with credit unions — it tends to go against the "philosophy" of deposit banking, which is to lend out only what has been deposited or used to capitalize the institution. A debit card would be consistent, but a credit card allows money creation through credit expansion without the necessity of first accumulating money savings. When this is done for consumption, it throws the system out of whack. Under the name of "usury" it has been forbidden by the three great monotheistic religions (Judaism, Christianity, and Islam), and most pagan religions and philosophies. (The fact that the prohibition against usury has been consistently violated for millennia no more invalidates it than the fact that murders occur invalidates "Thou shalt not kill.")

This is because a bill of exchange — the means whereby a private person or business enterprise creates money — is valued at the present value of existing or future marketable goods and services that the drawer of the bill of exchange either owns at the time of issue, or expects to produce within a reasonable period of time (traditionally 90 days, the most common term for commercial paper in the old days). Creating money in this way ties the new money to actual hard assets, whether the existing inventories, or the capital to be used to produce the future marketable goods or services.

Creating money for consumption goes contrary to this approach, and is backed by the borrower's presumed ability to pay out of other assets not directly related to what the money was created to finance. Borrowing for food, clothing, shelter, education, or charitable contributions creates a liability without balancing it with and matching it to the present value of an existing or future asset. This violates basic accounting principles and sound financial practice.

As for checking accounts and credit unions — as long as the demand deposit (checking account) is backed by 100% reserves of cash deposited in the credit union, and not a promissory note that it would be illegal for the credit union to issue in any event, there should be no problem.

For Binary Economics the bottom line is, whether we're talking about student loans, consumer credit, government expenditures, or stock market speculation, using pure credit for anything other than properly vetted, financially feasible capital investment, we either should not be using credit at all, or borrowing out of existing accumulations of savings. There may be circumstances that warrant the use of pure credit for non-productive expenditures, but these must be recognized only as expedients in an emergency, and not the application of a principle of Binary Economics.



Jether said...

"using pure credit for anything other than properly vetted, financially feasible capital investment"
Michael, what if it´s not available a truly necessary professional for a job involved in this feasible capital investment? (I´m not saying decades of study for a vague contribution.) Maybe you shouldn´t rule out any student loans from Kelso´s proposal.

Larry Walker Jr said...

Well done. This makes sense!

Michael D. Greaney said...

Jether — We don't rule out student loans, just pure credit student loans, that is, creating money for something that does not directly generate its own repayment.

If student loans are necessary (and, in light of the rapid rise in education costs, we can assume as a given that student loans are going to be necessary until Capital Homesteading gets enacted and has been in place for 20 years or so), funds should be raised through taxation or charitable contributions — redistribution.

Creating money for non-capital projects is, in fact, simply an indirect form of redistribution through inflation, as even Keynes admitted ... although he changed the definition of inflation to make it sound good.

To maintain a stable and sound currency, it is better not to inflate or deflate the currency at all, even as an expedient, but to use the tax and charity system to redistribute, while at the same time making it possible for people to start earning capital incomes so that they are no longer dependent on individual charity or State redistribution.

The bottom line is, yes, make student loans, but not by inflating the currency, which is the inevitable effect of creating money that is not backed by existing inventories of marketable goods and services, or the capital that will generate future inventories of marketable goods and services.