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The Quirky Nature of Credit

June 14, 2002

One change in the fabric of American finance that is particularly striking over the years is the proliferation of credit and the growth of nonbank financing.  The primary creditors of the nation’s debtors are not banks, but are so-called nontraditional lenders--such as GE Capital, the financial services arm of General Electric (which, interestingly enough, provides 40 percent of GE’s total earnings. And you thought GE made money selling stuff!). 

This was highlighted in a recent Wall Street Journal piece, where it was pointed out that GE Capital’s total assets of $425 billion exceed all but three banking conglomerates. According to the article, banks and thrifts contribute a proportionately smaller share of financing to the nation’s credit market today compared to years past. The Journal comments, "Twenty years ago, banks and thrifts supplied 40 percent of the nation’s credit. Ten years ago, it was 26 percent. Today, its down to 19 percent." 

Credit and finance have become the business of America, no longer dominated by banks, thrifts, and their ilk. The Wall Street Journal notes that approximately 40 percent of the earnings from the companies in the S&P 500 came from lending or other financial activities. Many retailers issue credit cards through banks that they own.

Naturally, the question arises as to what the consequences of such a trend might be, particularly given the quirky nature of credit, soaked as it is in a paper-based monetary system.

The Wall Street Journal reporter opines, "The benefits of this change in the financial underpinning of the economy were evident during the recession. As banks tightened lending standards, alternative lending and capital markets took up the slack." 

He points to the well-publicized zero-percent-financing offers by auto manufacturers and to companies like Boeing Capital, which lent UAL $700 million to buy planes when the capital markets shunned them. The old guard of easy credit also helped grease the axles, as Fannie Mae's and Freddie Mac’s assets have risen 21 percent and 35 percent, respectively, since the end of 2000.  These two behemoths alone hold as much mortgage debt as all commercial banks combined. 

Bank assets, in contrast, rose "just 8 percent," the reporter ruefully tells readers.

So here, the unwritten assumption is that keeping the spigot of credit open is better than the alternative. Credit is the fuel that feeds spending, and spending, so the conventional thinking goes, is the key to economic growth. The more companies offering credit, the more readily available it becomes, making everybody better off. Easy credit means easy money, ergo prosperity.

For every creditor there is a debtor

One has to wonder if more credit is a good thing. After all, every dollar extended in credit creates a corresponding liability or debt. In theory, at least, debts must be repaid. The risks of debt and leverage become muted under the sunny optimism of boom-time economics. However, the realities of leverage do not change because they are ignored; like the fundamental forces of nature, suspension of belief does not diminish their power. Leverage in finance is similarly unrelenting. 

The economist Benjamin Anderson explained the Great Depression in terms of a great excess of credit. He called cheap money the "most dangerous intoxicant known to economic life."

"Artificially cheap money," Anderson wrote, "…created a vast fabric of debt, internal and international. As the volume of this debt grew, its quality greatly deteriorated." He noted that "the period 1931 to March 1933 saw the progressive collapse of the unsound portions of this vast fabric of debt."

To take on a lot of debt is to exhibit a great deal of confidence about what lies ahead and in your ability to pay it back. It is also a matter of belief on behalf of the creditor. Debt, in essence, is a bet on a rosy future.

While no one can predict the future, it is safe to say that no one can borrow indefinitely, either, for the simple reason that there will be a limit to what a consumer--or business, or government--can borrow and yet still remain solvent. It is sort of a natural law of credit that as the volume of credit expands to more and more debtors, the quality of such credits deteriorate. Not everyone is creditworthy, and as the pool of credit widens, the fringes are shallower than the deeper center in terms of financial resources.

As Greenspan talks positively about the health of the U.S. banking system, one also has to wonder whether a strong banking system matters, given its diminished role in providing credit (and letting pass, uncontested, the idea that the U.S. banking system is healthy--a highly debatable point). Consensus opinion holds that the Fed has some control over the money supply through its traditional means of manipulating bank reserves and interest rates. How much of that is cast into doubt, since nonbanks are doing the bulk of the lending?

To his credit, the Journal reporter also notes that all this credit has a downside. Steve Galbraith, an investment strategist with Morgan Stanley, is quoted as saying, "Banks are not the place to be looking for the next blowup . . . because of the greater importance of these nonbank financial companies, odds are you’ll get a hiccup in this area." 

Which begs the question: What would the impact be if a GE Capital or Fannie Mae started to have financial difficulties? Would the effect be as deleterious as a failing banking behemoth? And would the Feds bail them out, too? In the span of less than a year, the government has, in one way or another, "saved" airlines, domestic steel manufacturers, domestic lumber producers, and, most recently, American farmers. How likely is it that the government will be able to resist saving Fannie Mae?

Some will advocate increased regulation of these nonbanks to conform with, or exceed, existing banking standards. But these are superficial remedies for a problem that lies much deeper. We’ve had banking regulations and numerous oversight bodies for a long time, and that has not stopped financial crises from developing. The problem is the money itself.

The Satanism of money and credit

The quirky nature of credit is that it is not necessarily better in abundance. It’s not like beer, butter, and bananas--where more means cheaper, and cheaper is good. Credit is like money; it represents buying power. Garet Garret called money's paradoxical quality the "Satanism of money." When it is plentiful enough, it is not worth enough, but when it is worth enough, it is not plentiful enough. The same sort of thinking applies to credit. More credit means more buying power, which means a bidding up of assets and a spark for an unsustainable boom.

Murray Rothbard wrote that "credit expansion always generates the business cycle process, even when other tendencies cloak its workings." Many economists and commentators point to the relatively low inflation rate during the boom years and the low-interest-rate environment of those years. "But prices may not rise because of some counteracting force," Rothbard notes. Indeed, productivity growth, an increase in the supply of goods, and an increase in the demand for dollars can absorb the increase in money, temporarily masking its inflationary effect.

The great merit of gold as money lies in the fact that the quantity of gold is limited by nature and by the amount of human energy and capital dedicated to mining it. As a result, gold holds its value. Wilhelm Ropke once wrote, "In the course of the centuries, no wager has been more of a certainty than that a piece of gold, inaccessible to the inflationary policies of governments, would keep its purchasing power better than a bank note." Gold acts as a natural limit to money, and for that it will always be the enemy of inflationists and governments.  

The flaw in today’s financial system is that these limits do not exist. Doug Noland, writing for PrudentBear.com, observed that the "…character of money and the contemporary credit-based system’s ability to create uncontrolled quantities is a crucial ingredient in precarious financial excess." According to Noland, "the explosion of nonbank entities easily explains the relatively slow growth of bank assets (loans) in the midst of historic credit excess."

The fact is that you can’t look just at banks or the Fed anymore. There are many more purveyors of credit than banks. All of this growth in credit has put in motion the boom-bust sequence predicted by Austrian theory.

The state of American credit is already weakening. There are only eight AAA-rated companies left in America (General Electric, UPS, AIG, ExxonMobil, Johnson & Johnson, Berkshire-Hathaway, Pfizer, and Merck), compared to 27 in 1990 and 58 in 1979. The first quarter of 2002 was one of the worst quarters on record for corporate bonds. Some 47 issuers defaulted on their debts, for a total of $34 billion in bad debt.

Personal bankruptcies are at record highs. More consumers filed for bankruptcy in 2001 than in any other year. Savings are low, and an increasing percentage of disposable income is being used to service debt.

Of course, these concerns also extend to government--the worst offender of all. The U.S. government cannot control its appetite for spending, and year after year, it spends more than it takes in, going ever deeper into debt. Many will probably be surprised to learn that government debt continued to grow even during the Clinton years, despite the administration’s claims that the budget was balanced each year. Government borrowing continues to reach new highs with each passing year. 

As The Wall Street Journal reported, in March of 2002, total federal debt stood at $5.924 trillion, and the Bush administration was seeking to raise the limit to $6.7 trillion. As Representative Ron Paul observed, "the federal budget is essentially a credit card with no spending limit, billed to somebody else." Moreover, as Paul observes, politicians come and go, but "the benefits of deficit spending are enjoyed immediately by the politicians, who trade pork for votes and enjoy adulation for promising to cure every social ill."

The only solution to these problems--the explosion of credit and debt, the gradual destruction of the currency, the boom-bust sequences--is to wrest control of money from government hands and back into the market. Let the market decide what should be money. For centuries, gold was the money of choice, and there is a growing suspicion that it will be again.

Christopher Mayer is a commercial lender for Provident Bank in the suburbs of Washington, D.C.  Send him MAIL and see his Mises.org Articles Archive.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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