The Stock Market, Credit and Capital Formation

CHAPTER XV

INDUSTRIAL INVESTMENT AND THE QUALITY OF CREDIT

97. We have still to give an answer to the question whether credit is liable to exert different effects, according to the purpose for which it is granted. It was necessary to clarify first the problems connected with the distinction between circulating and fixed capital. Now that we have progressed thus far, we may venture to comment on the effects of loans which are differentiated according to the kind of use to which they are put.

Are the effects of credit dependent on its use?

The answer is simpler in the case of transfer credit than in the case of inflationary credit. In the case of genuine savings it has been customary in the literature to inquire whether there is congruence between the duration for which the credit is granted and the duration for which the investment is made. We have already observed (§ 84) that from the point of view of the economic system as a whole, short-term credits can rarely be regarded as short-term investments. The division of functions in the productive process may cause what is from a collective point of view a long-term investment to take on the appearance of a short-term investment from the private point of view. If the demand for short-term credit predominates on the market, then the spread between the interest rates will tend to cause the available credit supply to take the corresponding form. If the demand for long-term credit predominates, then an increasing proportion of the available supply of capital will go through the stock exchange. The raising of capital through the issue of stocks makes the individual firm independent of the length of time for which the individual capitalist or speculator wants to invest his funds (§9). There has consequently been a tendency for industrial capital requirements to be financed to an ever-increasing extent on the securities exchanges, and the amount of industrial credit which has been obtained via the stock exchange is far greater than all other forms of credit.

New short-term credits usually mean long-term investments for the economy as a whole.

At certain times (prior to the nineteen thirties) the securities exchange was the only channel through which credit flowed into industrial production. Towards the end of depression periods capitalists and financiers held back from all long-term commitments, and at the same time entrepreneurs, after their bad experiences of the crisis, fought shy of borrowing at short term for investment purposes. Thus there was for some time almost no supply of long-term funds to industry and almost no demand for funds on the money market. The link was often re-established via the securities market. The belief that funds invested through the securities exchange can be withdrawn in liquid form had the effect of causing the superfluity of funds on offer on the money market eventually to find its way onto the securities exchange, in the first instance, of course, onto the bond market. At this point loans to customers who wanted to make security purchases, and security purchases on their own account, were the only outlets which the banks had for the vast funds which they commanded. It was not considered permissible to make direct long-term loans to industry out of these funds, and there was no demand for short-term loans by industry. The only investment outlets which remained open to the banks, therefore, were security loans and security purchases, in other words, indirect long-term credits to industry.1 (In recent years, of course, their place has been taken by the financing of public works and other public loan expenditures.)

After long depressions with no supply of long-term funds and no demand for short-term funds, securities markets often bridged the gap

Frequently credit, perhaps after a couple of transfer operations, will take whatever form is dictated by the demand. It is therefore rather idle to try to distinguish the effects of the credit according to the form and use originally intended. The length of time for which the funds are invested is likewise dictated by the demand, and as will be shown below, the term for which the credit is designed by those who originally supply it, is not what is finally decisive. Therefore a rise, followed later by a decline, in the amount of short-term transfer credit—no less than a credit-creation cycle—is capable of giving rise to marked disturbances. Even the most careful selection of borrowers cannot prevent this.

Term, form, and use of the credit are not determined finally by the will of the lender.

98. If one wished to distinguish the effects of a new credit according to the use to which it is put, one would have first to assume that without this credit the borrower concerned would not have succeeded in obtaining funds. This assumption is important because, if it is not fulfilled, the effect of the credit is entirely independent of the direct and concrete use to which it is put. For if this use would have been covered in the absence of the granting of this particular credit, the real beneficiary of the increase in supply is a borrower who was previously excluded from the market but is now able to obtain funds and who remains in concreto unknown (§ 83). It is important to assume also that the impetus comes from an increase in the supply of credit and not from an increase in the demand. (This assumption, however, detracts considerably from the practical importance of the question.)

If the borrower could have obtained funds in any case, it is not he who is the actual beneficiary of the new credit.

In accordance with these assumptions we may suppose that an entrepreneur receives a loan for productive activity (or for an expansion of productive activity) which he was unable to carry out previously for lack of the necessary money capital. Now that he is equipped with the money capital, the entrepreneur will be able to attract the means of production (original factors as well as intermediate products) to his enterprise. A theory which started out from the assumption of full employment would have to say that the means of production which are demanded with the new money capital were previously destined to go to other producers. If the new money capital is the result of the creation of credit, the diversion of the means of production to the new productive activity will take place by way of the bidding up of prices on the market. Professor Strigl concluded from this—I think justifiably within the narrow confines of the assumptions stated above—that the credit can only find employment in those lines of production where the increase in prices of the means of production plays a smaller rôle in cost calculations than the fall in interest charges.2 This would not be the case where the credit is used as “circulating capital” because, where working capital (materials that are used up in the process) is concerned, an increase in its price will be a weightier consideration than the reduction in interest charges. The reverse is true in the case of fixed capital, and it would therefore be profitable to use the additional credit only for investment in fixed capital.

The marginal borrower is likely to be an investor in fixed capital because of the relative weight of interest changes.

The answer to the question under consideration is in large part contained in the assumptions. It has been assumed that the demand is given and that the supply of money capital increases. The result must therefore be the satisfaction of a demand that was previously unsatisfied. If this investment opportunity which can now be exploited with the aid of the newly created credit was previously excluded by the competition of other ways of using money capital this must obviously have been due to the interest factor. Investment opportunities which cannot be taken up because credit is “too dear” must be of the kind where the interest factor plays a relatively large rôle: this is only the case with long-term investments. An investment which is made possible only by the creation of new credit can therefore only be an investment in fixed capital.

Generations of practical bankers, and authors of books about banking, have preached that bank credit should not be used for investment in fixed capital. Even if the length of the period for which working capital is invested is greater in the economic system as a whole than in the single undertaking, it will still be possible to liquidate working capital with less difficulty and at smaller loss than fixed capital. The “inflationary effects” should therefore be milder and less harmful if a credit expansion serves to finance working capital than if it is used to finance fixed capital. But is it possible to prevent the credit from being invested in fixed capital? The foregoing exposition, based on the assumption of a given demand for credit, leads one to answer this question in the negative. But is the “given” demand for working capital really perfectly inelastic?

Bank credit was supposed to finance working capital,—

—which might be more easily liquidated than fixed capital.

Is the demand for working capital perfectly inelastic?

Technically, an increase in working capital might take place without any increase in fixed capital if production could be extended within the limits allowed by the existing fixed capital equipment. The volume of production, at any time, is determined by marginal cost and marginal revenue. The marginal costs, i.e., the increase in total costs due to an increase in production, consist for the most part in wages and raw material costs. The interest on the investment in wages and materials is of relatively minor importance and the effect of a decrease in the interest rate on marginal costs is microscopically small. This is explained by the fact “that we have there a fraction of a fraction of a fraction. The volume of working capital is only a ratio of the total annual prime costs, a ratio which depends on the rate of turnover; naturally, the interest on the working capital is only a percentage of that; and finally, a decrease in the rate of interest is only a fraction of the latter.”3 The marginal cost curve will hardly fall noticeably in response to a reduction in the interest rate, and it is scarcely worth talking about a fall in the interest rate leading to an extension of production within the existing fixed capital equipment.

A substantial fall in marginal costs leading to an increase in output in given plants cannot result from a fall in interest rates;—

—interest is not a significant cost factor in the short run.

The increase in the supply of money capital can, however, raise the demand for certain products and may thus lead to an extension of production through the rise in the marginal revenue curve. There are here three possibilities:

More working capital may be sought,—

(1) If the increase in the supply of credit is inflationary in origin money incomes will rise and this will lead to an increase in the demand for consumption goods which can be produced with the existing capital equipment.

(2) The fall in the rate of interest diminishes the interest charge on the carrying of stocks by traders, and may cause the latter to increase their demand for goods to hold in stock.

(3) The fall in the interest rate raises the present value of durable instruments of production and increases the demand for them.

The first of these three possibilities (aside from the financing of consumption out of public funds) is not a direct effect of the augmentation of the supply of credit. The money incomes rise not as the direct result of the increase in the credit supply but as the result of the utilization of the credit, and, moreover, only as the result of the utilization of inflationary credit. But here we are concerned with the form of the primary use of the credit, to finance either working or fixed capital of producers. The possibility that the utilization of the credit may lead to a secondary demand for consumers’ goods, and that this may lead to a tertiary derived demand for working capital, is another matter.

—if secondary spending of new funds creates increased demand subsequent to the primary investment;—

The second possibility is the fundamental idea behind Hawtrey’s theory of the trade cycle. It has often been objected to this, that the demand of traders for stocks is influenced by interest costs only to a minute extent. There is a good deal of truth in this objection: it is not at all likely that the interest-rate-sensitivity of the traders’ demand for stocks will be anything like as important as the interest-rate-sensitivity of the producers’ demand for fixed capital.

—if a lower interest rate persuades traders to stock up;—

The third possibility brings us back to our thesis that the increase in the supply of credit will as a rule cause more credit to be used to finance fixed capital. The utilization of additional credit for extending production without simultaneous or previous investments in fixed capital is hardly likely to take place.

—if there is more investment in durable equipment.

99. The misdirection of investment would, it is true, not have such far-reaching effects if the money capital were used to produce “liquid” goods instead of being used to construct fixed capital equipment. This is so, not so much on account of the “period of turnover of the capital” or the slower or quicker rate of amortization, as on account of the greater or lesser variety in the purposes for which the concrete capital goods can be used. The loss of value is usually in inverse proportion to the number of uses to which the goods can be put. Since fixed capital goods mostly consist of the type of capital that is least capable of being used for a purpose other than that for which it was originally intended, they are the ones that are most likely to be subject to capital losses.

Loss of capital is related to both durability and specificity of equipment;—

Considerations such as these, however, are neither of theoretical nor of practical importance, for, as we have seen, the desire to find exclusively “mobile” investments for the additional credit cannot be fulfilled. Circulating capital will be increased as the result of the credit expansion only to the extent that (1) the fixed capital equipment that is first constructed with the aid of the inflationary credits needs raw materials as complementary goods to go with it, and (2) the increase in demand for consumers’ goods, which results in due course from the increase in money incomes, gives rise to a derived demand for working capital.

—investment opportunities in working capital can be expected only through joint and derived demand; joint with fixed investment, and derived from secondary spending.

Our conclusions may seem to conflict with the facts of experience, and practical bankers in particular will defend themselves energetically against the insinuation that they grant their customers short-term credits for long-term investment. Conservative bankers are convinced that they finance only goods in process and give only advances on goods sold. But they forget that by giving the producers these funds for investing in “working capital” they put those producers in the position of being able to use their own capital in a different way than formerly. The granting of the bank credit to the producer frees the funds which were previously tied up in the running of his business, and he can now undertake the investments he plans with his “own funds.” The concrete visible use to which the new credit is put is not, therefore, in any way identical with the investment which the credit has de facto made it possible to realize.

The banker cannot know the indirect uses of the funds which he lends;—

The investment which the credit expansion makes possible need not even take place in the firm of the actual borrower. Bankers could otherwise adopt the simple expedient of refusing any kind of loans and advances to entrepreneurs who undertake investment in fixed capital. In fact, however, the bank credit which the entrepreneur borrows for himself in the first instance may be re-lent by him to somebody else in the form of a trade credit, and thus make it possible for the firm which directly or indirectly takes over the products of the first entrepreneur to embark on investment. Or the bank credit may place the entrepreneur in the position of buying more on a cash basis and less on trade credit, and so enable the firms which directly or indirectly supply him with materials to undertake investments. Lastly, the bank credit may release some other credit and so, by easing the general credit market, make it possible for investment to be undertaken at some undeterminable point in the economic system. The great care which a banker takes in choosing between would-be borrowers will, of course, react beneficially on the quality of the bank’s investments, but it will not prevent additional credit from leading to the immobilization of capital somewhere in the economy.

—their real investment may be in other firms.

Careful selection of borrowers may protect the bank from losses but not the economy from immobilization.

100. If it is the inherent tendency of new credits (whether they be transfer credits or credits newly created by the banks) to find their way into investments in fixed capital, and if it is, therefore, of no avail to attempt to direct the credits into certain outlets by lending in a particular form and under particular conditions, then the mistrust of stock exchange credits with respect to their “quality” is groundless. We are no longer talking of the charge against stock exchange speculation that it may take the newly granted credits away from industry. For, in so far as one were concerned merely with the problem of how to prevent short-term credit from being used for fixed capital investment, the stock exchange would have to be praised and blessed if it actually did withhold the new funds from industrial investment. What we have to consider here is whether the “misuse” of the credits in production will not be made worse if the short-term funds are first transferred by stock exchange witchcraft into long-term funds.

If term, form, and quality of credit can not avert its use for fixed investment,—

“The harm which is caused by too much lending to the stock exchange lies in fact not so much in the possibility that there may be a shrinkage in the amount of lending to industrial borrowers,” says Reisch on this point, “as in the fact that in this case credits will be put at the disposal of the stock exchange which are by their economic character totally unsuited to the purchase of securities.”4 Commenting on this it has to be said that credits which are by their nature unsuited to security purchases are just as unsuited to any other kind of industrial credit. For if every additional credit may have the effect of a long-term credit, it is obviously immaterial in what garb this credit is dressed. This gives a final negation to the question raised at an earlier juncture as to whether the danger that investments will be misdirected is greater when the credit is granted to the stock exchange than when the same amount of credit is granted directly to industry.

—the banks stock exchange credits are no better and no worse than equal amounts of direct credit to industry.

Aside from the fact that the effect of the credit is not decided by its outward form (discount, security loan, overdraft, &c.) nor by the way in which it finds its way into production (through loans to producers or traders or through purchases of securities, &c.) nor by the concrete purpose for which it is used directly (trade credit, working capital or fixed capital), the banks have no means of damming up the flow of newly created credit to the stock exchange. So long as the expansion of credit continues, the newly created credit will flow onto the stock exchange even though the authorities send a policeman after every credit. When rates on call loans rise considerably above the discount rate, the banks attempt to rediscount their holdings of bills in order to be able to use their funds on the stock exchange. If the banks, under the pressure of the official credit policy, do not dare to expand their lending at call, but there is nevertheless a tendency for the credit expansion to continue to the benefit of “legitimate productive activity,” then ordinary business men will create commercial bills and will divert the “direct credits to industry” to the stock exchange. For nobody will prevent industry—attracted by the high rates on call money—from placing its liquid funds, of which it will have an abundance in consequence of the “legitimate industrial credits,” at the disposal of the stock exchange and from financing new issues with them at the same time. In periods of boom—periods of credit inflation—practically every credit becomes a stock exchange credit.5 The campaign against stock exchange credit will be brought to a successful conclusion only when a check is placed on credit expansion. And the check on credit expansion by the banks will not necessarily in all circumstances stop the increase in stock exchange credits immediately. Thus, for example, the restrictive credit policy of the American monetary authorities in 1928 achieved small success because the expansion was stimulated further by the reduction in the liquidity preferences of the economic system.

Besides, the direct loans to “legitimate business” cannot be kept from being passed on to a booming stock exchange.

The notion that it is possible to pursue an “effective” credit expansion and at the same time to avoid a stock exchange boom is absurd. Discrimination in lending is bound to fail so long as the discrimination does not imply restriction. This is, of course, possible and practicable: the demand for direct business loans and discounts might rise more slowly than the demand for security loans, so that a discrimination against security loans would act as a check on credit expansion in general. So far, however, as credits are created, they will tend, even when they flow straight into industry without first going through the stock exchange, to increase the demand for productive goods and in consequence to raise the value of plants producing means of production. This is bound to be reflected in an increase in the values of titles to these undertakings. Thus the same picture of a boom on the securities market will be presented no matter where the increased credits are initially placed.

Qualitative credit control is effective only if it involves quantitative restriction.

“Effective” credit expansion and stock exchange boom always march together.

It is thus a mistaken judgment to regard security loans as the villain of the piece and to look upon discounts as being devoid of all evil. For both, either visibly or invisibly, tend to follow the path that offers the greatest attractions. It is not the form the credit takes nor the exact place where it enters the system that makes it dangerous: it is, instead, its amount.

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