THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

Wednesday, August 26, 2020

The First Principle of Finance

      As we saw in the previous posting on this subject, when people have an inadequate understanding of money and credit, they necessarily get themselves into a bind called “the Economic Dilemma”: that you can’t profitably finance new capital without increasing demand to justify it, but you can finance new capital at all if you don’t have the money savings accumulated from decreasing demand!

 

Of course, once you realize that in addition to “past savings” (savings resulting from past reductions in consumption) there is also “future savings” (savings resulting from future increases in production), the Economic Dilemma resolves itself.  If people are depleting past savings and increasing consumer demand, financing for new capital formation can come out of future savings.

As we will see today, in a “perfect world” (a reductio ad absurdum, as we will never have a perfect world, regardless what the politicians of either party tell us) new capital formation would all come out of future savings, and all consumption would come out of past savings.  Of course, in the sense used here, even unspent current income counts as “past savings” as it represents income not (yet) spent on consumption.

 

But what about consumer credit?  Does that fit into the “past/future savings” paradigm?  Absolutely.  In the sense used here for savings, consumer credit is of two types, one legitimate, the other illegitimate.

Legitimate (in the sense used here for savings) consumer credit consists of some form of lending past savings for consumption purposes.  This is the function of credit unions and similar institutions — “banks of deposit” — that accept deposits and make loans.  A bank of deposit cannot make loans that exceed the amount of its capitalization and deposits, as it cannot create money.

This also includes finance companies that secure the new money they create with the consumer durables being financed . . . although this is somewhat questionable and more than a little gray, as the goods being financed almost always depreciate in value the moment they are purchased.  Who isn’t familiar with the fact that a new car loses 10% of its value the moment it is driven off the lot, and 20% per year after that?

 

Nor is real estate any better, especially in a volatile market.  As a general rule, the only time new money should be created is for existing inventories of marketable goods and services (usually expected to be sold within ninety days) or for an asset that generates its own repayment out of its own earnings, not out of gains — or losses — in the underlying asset.

Illegitimate consumer credit consists of creating new money to lend for immediate consumption or for something that is not a “consumer durable” with a stable value (which almost never happens).  This is what the consumer credit card companies do: create money for immediate consumption, to be repaid out of income not directly related to the purchase.  This gives us another general rule for consumer credit: that money should not be created for consumption.

Bill of Exchange
 

This brings us to what financial historian Benjamin Anderson called “the first principle of finance”: to know the difference between a “mortgage” and a “bill of exchange.”  That (as we might expect) requires a little explanation.

A mortgage is a financial instrument backed by an existing asset owned by the drawer or issuer of the mortgage.  While most people are familiar with a home mortgage, a mortgage is actually more common in “the money market.”  By using a mortgage, a company is able to raise money on its existing inventory, essentially “pre-selling” inventory now for immediate cash.  As the inventory is sold, the company uses a portion of the profits to redeem or “buy back” its note from the mortgage holder.  A mortgage bears interest as it represents an existing asset.

A banknote not issued for circulation, but for banks
 

A bill of exchange is a financial instrument backed by the present value of a future asset or income owned by the issuer.  A simple way of understanding the difference between a mortgage and a bill of exchange is that a mortgage is backed by the asset on which it is drawn, while a bill of exchange is backed by the “creditworthiness” of the issuer.  This is why with a mortgage, title to the asset passes to the holder in due course of the mortgage, while with a bill of exchange only a claim on the future asset passes, not legal title . . . since you can’t take possession of an intangible the same way you can take possession of a marketable good.  A bill of exchange is “discounted” instead of bearing interest (that is, a bill of exchange with a face value of $100,000 is discounted at issue for, say, 2% for 90 days, meaning that it is “worth” $98,000 as money when offered and accepted at issue, but is redeemed at the full face value of $100,000 90 days later) because the asset is not yet in the possession of the issuer, and the discount depends in part on how trustworthy or creditworthy the issuer is.

Interestingly, there is a special type of bill of exchange that is widely used today throughout the world, even though the largest economy in the world does so illegally (technically).  This is the “bill of credit,” which is a bill of exchange issued by a government in anticipation of future tax revenues . . . that it might never receive!  That is why bills of credit are also called “anticipation notes.”

 

Ironically, the U.S. Constitution does not give Congress the power to emit bills of credit.  The Articles of Confederation and the first draft of the Constitution did have a provision permitting Congress to emit bills of credit, but after the fiasco of the Continental Currency, the framers of the Constitution removed it.  Bills of exchange, by the way, are “issued,” while bills of credit are “emitted” or “uttered”; the last signifying the thing is of value only because the issuer said so or “uttered” it, i.e., fiat money — “utter” is usually confined to counterfeiting due to the pejorative implication; “fiat” sounds much more classy, even though it means the same thing in this instance.

Taking all of this into account, we can formulate a general rule for savings: past savings should be used for consumption, whether direct consumption, government expenditures, and gambling and speculation.  Future savings should be used for new capital investment.  “No savings” — new money created for government expenditure or for consumption — should not be used for anything at all.

Are there exceptions to this general rule?  Of course.  We don’t live in a perfect world.  But we should be extremely cautious about departing from the rule, and we should never, repeat, never make exceptions the rule as Keynesian economics does.

Of course, the next question to answer is, How are we supposed to adhere to this rule?  That is what we will look at when we address this subject again.

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