Tuesday, September 22, 2015

Banks and the Stock Market, IX: Bad Credit v. Good Credit

It took us a while, but we’re now coming to the whole point of this series: how misuse of the banking system by both the private sector and the public sector has undermined the basis of a sound market economy and inhibited (in some cases prevented) economic growth.

The simple fact is that certain types of banks create money by extending credit.  That is not the issue.  It’s a fact.  End of story.

Bad uses of credit: debtors prison
Or, rather, end of chapter.  The story goes on.  The next chapter is called “Bad Credit v. Good Credit.”  As usual, the bad gets top billing — would you have read a novel titled Peace and War?  Or Come With The Wind?

By “bad credit” and “good credit,” we’re not talking about whether someone is creditworthy, i.e., has good credit.  What we’re talking about is whether the credit itself is used properly, i.e., in a “good” way.  This can get complicated.

The first rule of credit is that there is really no difference between credit and money.  Recall our quoting Henry Dunning Macleod earlier in this series, “Money and Credit are essentially of the same nature; Money being only the highest and most general form of Credit.” (Henry Dunning Macleod, The Theory of Credit. Longmans, Green and Co., 1894, 82.)

Henry Dunning Macleod
The second rule, as we hinted earlier, is that it is a serious error to confuse money — the symbol of value — with value itself, i.e., to treat money and credit as a commodity.  No, money is not valuable in and of itself.  It is valuable only because it represents something of value.

True, this can get confusing and very complex.  A piece of money, say, a banknote for $1, is not itself a thing of value.  It is of value only because it is backed by a promissory note issued by the bank to back the banknote.

Does that mean that the promissory note is the thing of value?  No.  The promissory note is valuable because it is backed by a bill of exchange or mortgage accepted by the bank that issued the promissory note that backed the banknote.

Does that mean that the bill of exchange is the thing of value?  (And by this time you’re sighing and very confused.)  No.  The bill of exchange or mortgage is valuable because it is backed by the creditworthiness of the issuer of the bill of exchange or mortgage, i.e., the validity of the promise of the borrower that he or she will repay the money raised by offering the bill of exchange or mortgage to the bank and having it accepted — the borrower’s “word.”

Eighteenth Century bill of exchange
Does that mean that the promise of the issuer of the bill of exchange or the mortgage — his or her word — is the thing of value?  No.  Someone’s word is only valuable if it is kept, i.e., the person delivers on the promise made, that is, keeps his or her promise to turn over something of value when promised.

Now we’re getting somewhere.  It is the ability of the person to keep his or her promise combined with the expectation that he or she will do so that is the thing of value.  Its precise value depends on what the thing promised is, when it is to be delivered, and the likelihood that something will go wrong and the thing not be delivered.

The “value” of a bill of exchange, the symbol of the present value of future marketable goods and services, is thus “discounted” by 1) the value of the thing today compared with the value of thing at the term or maturity of the bill, and 2) the risk that the issuer of the bill won’t make good on it.

For example, suppose someone issues a $100,000 bill payable in 90 days discounted at 1% for the present value of the future marketable goods or services, and at 1% to allow for the risk that the issuer won’t deliver the goods or services as promised.

The bill is thus said to be discounted at 2%, or $98,000.  Anyone who accepts the bill doesn’t accept it at $100,000, but at $98,000 . . . until the bill is rediscounted.

That’s because the closer a bill gets to maturity, the easier it is to predict whether the issuer will make good on it.  On the day of maturity, then, the discount is 0%, and the bill is redeemed for $100,000, the face value of the bill.

Tobacco bill of exchange.
Obviously, a bill of exchange doesn’t bear an interest rate, even though some authorities call the discount rate “imputed interest.”  This is, technically, incorrect (even though the term is used) because “interest,” strictly speaking, applies only to existing savings (“past savings”), while bills of exchange are based on “future savings.”  The term “interest” comes from “ownership interest,” and you can’t own what doesn’t yet exist, although you can own a claim on what does not yet exist.

Thus, credit extended on a bill of exchange is “interest free,” but most certainly not “cost free.”  The issuer of the promissory note that was used to pay for the bill of exchange used in our example above gets $2,000 if he or she holds the bill to maturity.  Out of this the one who accepts the bill must meet any expenses and show a profit.

We didn’t mention what happens when a bill is past due, that is, has gone past the maturity date without being redeemed.  In that case, the bill is either dishonored or worthless, or the issuer promises to make good the bill out of other wealth later.  When that happens, the bill may bear an interest rate, because it now represents an ownership interest in other wealth owned by the original issuer of the bill.

A pawn is a small denomination chattel mortgage.
This leads us into a discussion of mortgages.  Where a bill of exchange represents the present value of a future amount that the issuer will owe when the bill matures, a mortgage represents the present value of an amount now that the issuer owes.  That being the case, anyone who accepts a mortgage is due an interest rate representing a share of the profits attributable to the goods or services.  The interest rate should be set by the market cost of capital, plus a premium for the risk that the issuer of the mortgage won’t redeem the mortgage.

Mortgages and bills of exchange are therefore “good” uses of credit.

We won’t go into “usury,” which is taking a profit when no profit is due.  Conceptually simple, it is extremely complex in practice.  We only need to note that extending credit and either discounting the bill or charging interest on the mortgage for anything that does not generate a profit is contrary to sound principles of finance.  It may be allowed for the sake of expedience, but it is not generally a good idea to make usury a cornerstone of a financial system.  Usury is therefore a “bad” use of credit.

In pure terms, then, bills of exchange should be used to finance economic growth — future increases in consumption — and mortgages should be used when dealing with existing marketable goods and services.


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