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.
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| 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.)
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| 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.”
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| 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.
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| 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.
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| 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.