Tuesday, November 6, 2012

Let's Make a Deal, III: The Trap of Non-Capital Credit

As we saw yesterday, a system in which most people do not have access to capital credit to finance new capital formation or enhance the productivity of existing capital is a system designed to fail. It increases variable costs of production, raises prices, and puts producers unable to obtain adequate credit for new or improved capital instruments in a perpetual "catch-up" situation, like the Red Queen in Lewis Carroll's Through the Looking-Glass.

An economy in which wage workers own little or no capital is thus analogous to a farmer who routinely sells his seed corn to meet debts incurred previously. The farmer then has to borrow again for more seed for the next crop, and hope that prices are high enough to generate the additional revenue needed to cover the cost of past seed, future seed, other operations, and provide sufficient income for consumption.

The farmers and the small businessmen of the latter half of the 19th century were in a bind caused by the design of the financial institutions of society and the manipulation of the currency under the principles of the British Currency School. Many of them had taken out loans during and immediately following the Civil War when, as a result of the inflationary policies followed by Salmon P. Chase, Lincoln's Secretary of the Treasury, money was "cheap." After the war there was a need to reestablish the faith and credit of the government and restore parity of the paper currency with gold — that is, make money "dear" again.

Consequently there was at first an official and then an unofficial policy of deflation to offset the 600% inflation during the war and bring gold and silver back into circulation. Prices fell. Thus, where farmers previously had to grow, for instance, a thousand bushels of wheat to repay a debt, they might have to grow two thousand to repay the same debt.

For another, the accumulated savings on which farmers and small businessmen relied for credit disappeared to repay debts or was used for consumption. There was little left over for investment. Farmers and small businessmen had to rely on mortgages based on the present value of existing assets to finance new capital formation, not the bills of exchange based on the present value of future assets available to the wealthy.

To explain, a bill of exchange is based on the creditworthiness of the borrower. It represents the present value of a future project — "future savings." The amount that can be borrowed is limited only by the financial feasibility of the project: the ability of the capital to pay for itself.

In contrast, a mortgage is based on something the borrower already owns, not on what he or she proposes to own. Mortgage financing thereby limits the amount that can be borrowed to what has been withheld from consumption in the past — "past savings." When operations are financed with a mortgage (as was usually the case with farmers and small businessmen), there is generally no increase in productive capacity that enables the borrower to repay the loan and continue to meet current consumption needs — nor, except in extraordinary circumstances (such as free or self-liquidating capital made available under a Homestead Act) can there be any expansion of productive capacity.

Instead, in such a situation, mortgage financing of operations (as opposed to new capital formation) creates a vicious circle. Existing capital is doubly burdened, having to produce at least at the prior level, plus enough to make the debt service payments. It comes as no surprise that, even in the best of times, few farmers and small businessmen were able to repay the principal, but were only able to make interest payments.

When the balloon payment came due, the loan was refinanced. If refinancing was unavailable due to scarcity of savings or decreased production (both of which occurred in the 1930s), the bank was forced to foreclose. Farmers lost their land, and small businesses went under.