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Credit

( Originally Published Early 1900's )

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1. Relation of credit to exchange processes.—It is not practicable to unfold the science of business with the same logical precision that can be applied, for instance, in geometry. Business is a living thing and its parts are so bound up with one another that we must of necessity use many terms before it is possible to define them or consider them in detail.

No discussion of prices and no discussion of money would be possible which did not introduce at least incidentally the terms credit and banks. While the technical details of banking and credit are reserved for other volumes of the Modern Business Texts, some general consideration of the nature and functions of credit is indispensable to a proper understanding of the general principles which underlie all business affairs.

In the development of successive methods of ex-changing goods, credit has been designated as the third and final step. The greater part of the world's business is transacted on a credit basis, and the examination of how this is brought about will not only intro-duce us to fundamental business activities but will serve to make clearer the processes which have already been explained.

2. Exchange without money.—The inconveniences of barter were largely removed by the use of money. Money has attained its present usefulness only after many experiments, but money is not without its limitations. Many of the objections to the use of money in larger transactions, which grew out of the bulk and weight of the coin, have been removed by devising the various forms of paper money described in the preceding chapter. Even with this relief to the mercantile community there has been a constant striving to do business without the actual use of money, not only because of its bulk, but also because it has been found that without using money directly, a much larger volume of business can be transacted.

With exchanges based on credit no money at all is used. Men buy and sell without possessing money and sometimes without owning property. The buyer gives instead of money, the promise to pay money. But the promise to pay money is not of necessity redeemed in money itself. This promise may be, and generally is, satisfied by the transfer of money's equivalent.

Money is sometimes spoken of as the "control over goods." It is this control which men need in business, not the money which gives it. If they can secure the control without the money they are perfectly satisfied. Hence the promise to pay money involved in every credit transaction is in the majority of cases satisfied by some act of the debtor which at the time of maturity transfers to the creditor. some form of control over goods or, as it was expressed before, money's equivalent.

3. What is credit?—Some indication of the meaning of credit has already been given, perhaps in quite as satisfactory form as in a formal definition. But the term is used in so many different senses, both in everyday speech and in the language of affairs, that it is well to determine in what sense it is to be used in this discussion. The common expression that a man is given credit for something, or that he has credit, means in mercantile life that he enjoys the confidence of the community and has the ability to borrow. This is the personal side of credit, which in the world of business is of great importance. The Modern Business Text on "Credit and the Credit Man" will deal extensively with this personal aspect of credit.

In the present discussion credit must be considered objectively. John Stuart Mill in his "Principles of Political Economy" defines credit as being the per-mission to use another's capital. Mr. H. D. Mac-Leod in his "Theory of Credit" informs us that credit is "a right of action." These two definitions present credit from two sides but each is an incomplete picture. Mill's definition of credit describes, tho briefly, the role which credit plays in modern business, while Mac-Leod approaches the subject from its legal rather than from its economic side.

A credit is so much more than the permission to use another's capital that it will serve our purposes better to amplify the definition of MacLeod and designate credit as the right to receive a future payment of money. If we keep this thought in mind it will enable us to understand more clearly not only what credit does but how it accomplishes results.

Such a definition of credit implies that some ex-change is incomplete. On the one hand, a quantity of goods or some other valuable consideration has been transferred, but the payment for it is postponed. All that is given in exchange is a promise to pay. This promise may be regarded as something definite because in various ways whoever obtains from such a transaction a right to receive payment can transfer that right before the payment is actually due, and thus come into the possession of the full fruits of the transaction. For its further utilization in business affairs, however, the form in which the promise or the credit is expressed is of the highest importance. If reduced to a promissory note, bill of exchange or similar instrument, it becomes at once impersonal, and can be bought and sold with comparative ease.

4. Kinds of credit. All credit arises in the process of exchange, either the exchange of credit for goods, credit for money, or credit for credit. If A buys goods of B, he may offer the price of the goods in gold or in bank notes, he may give his promissory note or he may give nothing but his simple promise to pay. When payment is made in gold no credit is involved.

The case is different when payment is made in bank notes. As we have seen, these circulate as money and have a wide acceptability, but back of them is the credit of the bank. They belong in that intermediate stage between standard money and credit which has been designated as credit money. When the purchaser offers his personal check and this offer is accepted, there is a payment thru credit. This is plain in the case of payment by promissory note or when there is only a simple promise to pay, but in the former case the credit is less personal and more general.

It is plain that these different forms of credit have different degrees of transferability. Checks, notes and personal promises or book credits represent three degrees of transferability, of which the first is the highest and the last the lowest.

5. Credit based upon money.—Credit is the right to receive a future payment of money, but if it were nothing more than this it would serve only a limited purpose. All credit is expressed in terms of money because all values are so expressed. If the credit is a simple book credit for 30 or 60 days and on the expiration of this time is canceled by a payment of gold the transaction is merely a money exchange with deferred payment. The same is true if a promissory note is given which remains until maturity in the seller's hands and is then paid in gold.

But if the seller takes the note to the bank and has it discounted, he transforms a credit of limited acceptability into one of much larger acceptability and is able to make use of an equivalent amount of capital.

If when the credit, whether a book credit or a note, becomes due the buyer cancels it by his check on the bank, the whole transaction has been accomplished without the use of money.

Credit always creates a right to receive money at a future date, and while in the majority of cases it is not money but money's equivalent which is received, it would be utterly impossible to understand all the workings of credit if it were not borne in mind that this right to receive money may be exercised. In-deed, the varying degree in which this right is actually exercised is largely responsible for what the business world knows as the cycle of prosperity, panic and depression.

6. Use of credit in industry.—Modern business requires capital for its foundation and its operation. It must have lands, buildings, machinery-a great variety of capital goods which make up plant and equipment. Furthermore, it requires raw materials, supplies and money to pay for services and for such expenses as taxes. Now, in the modern world it is not necessarily the owners of wealth who engage in production or direct industry. If the man behind the enterprise is not a capitalist and cannot induce capitalists to share with him in the risks and profits of the business he must borrow property from others. In so doing he goes into debt, and various kinds of credit obligations are created which must eventually be liquidated.

The particular form which these credits take depends upon a variety of circumstances, not only the sagacity of the borrower, but the purposes to which the money is to be put and the condition of the credit market. As a general rule, before credit can be obtained in any form the borrower must have some actual wealth which he owns or controls. Thus credit appears in the role of supplementing capital, and enabling the business man to verify the scriptural saying that "to him that hath shall be given."

The readiness with which credit can be commanded depends upon the reputation of the manufacturer or dealer for successfully selling his product, the amount of the credit and the nature of the business. Since all kinds of business are not considered by the, world at large as equally vital to the welfare of the community, there may in dull times be much greater difficulty in borrowing for one kind of business than for another.

Those who deal in food and in other necessaries of life are reasonably sure of selling their product under all conditions. Even in hard times credit is granted to those engaged in such business, where it would be denied in a business which could command a less certain market. But oftentimes men in these other lines of business have a reputation for successful selling which is so good that they can easily obtain credit when many of their rivals encounter extreme difficulty in so doing, or fail in the attempt. These conditions may well determine the form of credit. In some eases almost absolute reliance may be placed on temporary accommodations. In other cases it may be more advantageous to increase permanently the working capital by placing longer terms of mortgage upon the real estate used in the business.

7. Mortgages and bonds.—When capital is borrowed on a mortgage, real property is pledged for the payment of the obligation assumed. The ordinary small loan is made by means of a bond and mortgage, in which the bond contains the direct obligation to pay and the mortgage is the agreement, in case of non-payment, to transfer the property pledged to the creditor. Such a bond is in smaller transactions indivisible. In the larger transactions of corporations the bond becomes bonds which are fractional parts of and common obligation secured by a mortgage. Like short-term obligations these promises must be redeemed, but as they run for considerable periods of time the borrower is given the. opportunity to make the required payments from the accumulated profits of the capital which has been borrowed.

The purpose of loans of this character is to allow the borrower to use the proceeds in some more or less fixed or permanent investment. The railroad corporations of the United States have borrowed largely in this manner and the method is coming to be more and more general among the public utility corporations. On the other hand, industrial corporations have used this form of borrowing sparingly. When bonds are issued in this form it is expected that interest, will be paid from the current earnings of the corporations. Payment of the principal is sometimes provided at least in part from earnings, but is generally made from the proceeds of the sale of new securities.

8. Commercial credit--The borrowing on bonds and mortgages naturally suggests a contrast to ordinary commercial credit. When a dealer purchases goods on credit he hopes to have sold these goods again before the expiration of the credit period and to be in a position to meet his obligation from the proceeds of the sale. By such action he expects to gain in addition a profit for himself. This illustrates what Mill had in mind when he defined credit as per-mission to use another's capital.

Similarly, when a manufacturer buys materials on credit or borrows money on his note to pay wages, he hopes to meet such obligations from the sale of his product. There is in these cases a confident expectation that the whole amount borrowed will be replaced, as it were, by a single transaction. When money is borrowed for longer terms the replacement of the capital is only gradual.

The distinction between borrowing for investment purposes and borrowing for operating expenses is very important, altho it is not always observed either by those who seek or by those who grant credit accommodations.

9. Cost of credit.—Credit is an economic good and like other economic goods must be paid for by those who use it. In the case of bonds and certain longterm notes the price is expressed as interest. In the case of notes discounted at the bank the price of credit appears as discount. In some cases, indeed, no interest is apparent on the face of the transaction. When goods are bought on sixty days' credit, for example, the interest paid by the borrower is concealed in the price of the goods. In mercantile practice, wherever a specific discount is allowed for cash payments, the amount of the interest involved in payments on credit can be precisely calculated. There can be no doubt that such transactions always include interest, whether or not it may be readily calculated.

The rate of interest is determined by the condition of the credit market. Rates of interest on bonds and other long-term obligations appear to be fairly fixed, altho they vary somewhat with the demand for, and the supply of, such investments. These variations, in the case of bonds and similar securities, are more likely to find expression in the price of issue than in the interest rate. Generally speaking, railway obligations bear from four to six per cent interest, public service corporation bonds from five to six per cent and real estate mortgage bonds from five to seven per cent, according to the location and the value of the security.

On the other hand, the discount for commercial paper has a much wider range. It may be as low as three per cent when the market is easy and bankers are eager to loan. But as the demand for credit increases, rates of discount rise and in times of panic may be as high as 10 and 12 per cent. The average is perhaps from four to five per cent. The lower rate of interest for commercial paper sometimes prompts men who have no immediate prospect of repayment to borrow on short-time paper.

Naturally the borrower seeks the lowest rate of interest available. If he has borrowed at four per cent on short-time notes he is reluctant to issue six per cent bonds in their stead. If money becomes tight he seeks to make the change but is liable to find that the market will no longer absorb the bonds. The ad-vantage of long-term borrowing in certain lines of business is so great that far-sighted men of business will often forego the temporary advantage of lower interest in short-term notes in favor of the greater security of long-term obligations. When capital is borrowed on such terms the borrower has no fear of being squeezed in a tight money market which may jeopardize his enterprise.

10. What credit does.—This description of the conditions under which credit is obtained has incidentally given some idea of what credit does. It must be evident that credit directly adds nothing to the wealth of the community except perhaps as it draws in capital from other sources. If we take the world as a whole, the existence of credit does not of itself enhance the amount of wealth. Any inventory of the world's wealth would pass over credit, because credit is, after all, a relation between individuals, a question which concerns not the aggregate of wealth but its distribution among individuals.

The chief function of credit in the world of production is to distribute capital. Thru its agency the active, energetic men of the world are enabled to secure control of the capital needed in their enter-prises. Thus, while credit does not increase wealth it greatly increases capital, which has been defined as wealth devoted to production. It can therefore be readily understood why writers upon the subject have been disposed to sing hymns of praise in honor of credit, and extol in eloquent periods its beneficent workings. Thru its aid the world's production is vastly increased, and the creation of wealth is greatly stimulated. While it is not wealth, it is one of the most powerful factors in the creation of wealth. In-directly it serves to bring forth new stores of value, to create new means of production, favoring economy and providing for each generation a larger store of this world's goods than was possessed by its predecessors.

11. Credit and money.—All credit is expressed in terms of money, and back of it there must be certain reserves not only of capital, as has already been pointed out, but also of money. Such reserves are needed for the contingency that a portion of the credit obligations must be met by money payments. This is not the only relation of credit to money. As we have seen, the function of money which is most generally understood, and which was perhaps the first in point of time, is to serve as a medium of exchange. If anything besides standard money serves as a medium of exchange in just so far does it partake of the nature of money. Now under many conditions credit serves to make exchanges; thus it is described as a medium of exchange.

Some have pointed out that, as the majority of exchanges are made by the use of credit, credit and not money is the chief medium of exchange. This point of view is useful in calling attention to the services of credit but it should not lead to any misapprehension of the relation of money to credit, or the designation of credit, as money. Between the two there is a fundamental difference. As a medium of exchange money is universally acceptable, while credit has only a limited acceptability.

The relation of money and credit brings to light the great importance of the distinction between credit in general and credit instruments. The former does not serve as a medium of exchange in any degree except as it is transformed into the latter. If the use of credit merely postpones a payment of cash, and nothing more, it may serve a useful purpose to the individual but it does not in any degree perform a money function or diminish the demand for money. A credit instrument may, however, be used to effect any number of exchanges besides that which originally gave rise to it, and thus it may perform a real money service.

It is quite possible to conceive of notes and similar obligations as performing this function without the interposition of the banker. But in the modern world it is thru the banker that credit serves as a medium of exchange, and any explanation of things as they are must take the banker into account. He is the intermediary thru whom credit is distributed to those who desire to utilize it. While the full description of banks and their operation must necessarily be reserved for the Modern Business Text on "Banking," their relation to the general credit situation may be briefly set forth here.

12. Bank notes.—The methods pursued by the banks in different countries in loaning money vary. In some countries credit is extended chiefly thru the use of bank notes. The applicant for a loan receives its proceeds in the notes of the bank, which he uses as money for the payments that he has to make. Such notes are simply the promissory notes of the bank. People are willing to accept them because in form they are similar to money, and because the bank is known generally to be solvent. This solvency is maintained by holding in the bank a reserve of standard money with which to redeem the notes on presentation. Such notes are always payable on demand. The reserve of money held against them is either fixed by law or dictated by experience, but the reserve is only a fraction of the amount of the notes issued. With a reserve of 20 per cent, for example, the potency of money to effect exchanges is multiplied five times as long as the bank holds it in reserve for the redemption of notes issued against it.

The amount of gold held and the amount of notes issued against it varies with the demand for capital.

In dull times it is curtailed, and in easy times it increases in amount. These changes are brought about by the issue and the redemption of the notes. If notes are in excess of needs they flow back into the banks. In common speech such bank notes are usually spoken of as money, but the economist recognizes the important credit element which enters into them and calls them, as we have seen in the preceding chapter, credit money.

In the hodge-podge of bank note issues which prevailed in the United States before the enactment of the National Banking Act, there were some banks which issued notes on the principle which has been described and, in a general banking situation which has frequently been spoken of as riotous and chaotic, preserved an honorable record. But so many abuses arose that people regarded the issue of bank notes more as a government issue than as a function of credit. In the national banking system, regulation superseded redemption as a controlling principle in the issue of bank notes. Neither the national bank notes nor the Federal Reserve bank notes which are to replace them rest on the demand for capital, but on bonds deposited for their security. On the other hand the Federal Reserve notes as described in the last chapter rest in part upon this demand and can be issued to meet the, varying needs of the business community.

13. Bank deposits.—In the United States the development of banking credit has been chiefly thru the growth of the deposit and check system. Under this plan credits circulate thru checks and drafts drawn against deposit credits. Bank loans are not made by handing the borrower the proceeds either in its own notes or in other currency but by opening a credit to his account. Against this credit he may draw checks. The recipient of the check does not as a rule cash it, but deposits it in the same or another bank. Thru a bookkeeping arrangement in the bank, or an adjustment between the banks when two are involved, the right to draw checks passes to the new owner. By this process, indefinitely continued, the credit of the country is mobilized thru the banks and serves the purpose of a medium of exchange.

The volume of credit swells as the business of the country increases, and contracts when the business diminishes. It serves most, if not all, the purposes of money much better than money itself, among those who are accustomed to its use. Whenever large payments have to be made to persons not familiar with credit transactions money is required, and this strains the credit situation. The need of "money to move the crops" is a familiar illustration. When crops are harvested actual currency is needed to make payment for them. This seasonal demand for cash is, however, diminishing as the western farmer becomes more and more accustomed to the use of banks.

14. Liquidation of credit.—Thru the agency of credit a vast number of obligations payable in money are created. Obviously it would be impossible to redeem them all at one time. Against such credit there is kept a certain reserve of gold. If demands for redemption lessen the quantity, it must be replenished. It can be replenished only by curtailing credits. Such a process does not, as we have seen, lessen in any degree the amount of existing wealth, but none the less it may necessitate painful readjustments in business. Those who had counted upon the continuance of credit accommodations are forced to curtail or even abandon their operations.

If the demand for a liquidation of outstanding credits is widespread, panic and business depression ensue. Wealth is not destroyed. But the control of wealth passes more and more into the hands of those who own the wealth, and its activity is lessened. Capital or wealth used in production is diminished, and with the decrease in capital the creation of new wealth slackens.

On the other hand, in times of reviving business, the prospect of gain lures wealth into productive uses, and thru credit the available capital is increased. Permission to use another's capital, as Mill would say, is more and more freely granted. Thus it is that business is never stationary, that there arise alternate periods of prosperity and depression. The crux of the situation lies in credit.

No device has been conceived by society which will prevent these ups and downs, nothing which will give credit freely when credit is most wanted. But thru a wise adjustment of credit agencies much can be done to mitigate the severity of periods of stress and strain. It is hoped that the reorganization of our banking system thru the Federal Reserve Act has created an organization which in the future will make panics less severe than they have been in the past.

REVIEW

What are the economic and legal aspects of credit?

What are the principal divisions of credit which are important from an economic point of view, and in what does their importance consist?

Does credit economize or dispense with the use of money? What is the distinction between the two ideas?

How do the conditions of the credit market affect long-term and short-term credit respectively?

What forms does bank credit assume and what are the particular advantages of each?

How do bank deposits serve to effect exchanges?

What causes the fluctuations in the credit market?

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