Economic theory long has failed to fully appreciate the role of “credit” in an economy, while the idea of there being a “money supply” is an old one.
Undergraduates taking money and banking courses all learn how supply and demand determine interest rates in a market for “loanable funds.” But “credit” itself has far broader implications and effects in an economy. Ignore that in economic theorizing or modeling, and you likely will come up with faulty insights. In some cases, this can lead to tragic outcomes.
The financial crisis that began to unfold in 2007 is a prime example of where contemporary economic theory failed and where the result of that failure had grave consequences. Fortunately, at least a few economists are stepping back and trying to look at credit in a broader context. But it may be some time before this gets the attention of the big names in the discipline.
The word “credit” comes from the Latin “credere,” which means to trust or to believe in. Much trust is required to make a loan — either trust in the honesty and capability of the person borrowing the money or trust in the adequacy of any collateral and the legal institutions needed to seize it should the borrower be dishonest or incapable of repayment.
Loaning money or pledging other value in some tangible way inherently means taking on risk. Contrary to some economic theorizing, which disregards culture and societal institutions almost entirely, both trust and risk- taking are highly culturally determined, as are other aspects of credit. Moreover, human decisions in the offering or acceptance of credit frequently are far from the rational calculations assumed in econ theory.
Social attitudes toward indebtedness vary greatly between different nations and cultures. Taking on debt, even to buy a residence, is viewed as a momentous act in Germany, not something to be done lightly. When a debt is incurred, the general ethos is that it should be paid off as quickly as possible. Being indebted unnecessarily borders on a cause for shame.
The idea that one would refinance a house to pay off credit card debt or go on a cruise is alien. So are ideas that one should pay off a mortgage slowly so as to maximize one’s tax savings from a mortgage interest deduction or to maintain a high level of leverage to maximize capital gains if housing prices rise.
This is not to say German households or businesses shun borrowing entirely. But there is a different frame of reference both for families and businesses. The “mittelstand,” or small and medium-sized companies, often making specialized machinery or electronics, that are the heart of the German, Swiss and Austrian economies remain predominantly family-owned and often are self-financing to a degree that would astonish managers of similar-sized businesses in the United States.
Retaining earnings and plowing them back into new machinery or research and development rather than paying them out as profits is the core of such firm’s financial management.
German legal traditions accord with popular values. Bankruptcy is difficult, the laws punish those seeking discharge of debt, and a bankruptcy on one’s record is a black mark that will stand until the end of one’s life.
The United States stands out at the opposite end of the scale in terms of a cultural eagerness to take on debt and to try to get rich with other people’s money. Going into debt for speculative purposes goes way back to the establishment of the republic.
George Washington was just one of the founding fathers who took a major venture into land speculation west of the Alleghenies.
In the 1820s and 1830s, such speculation in land on the frontier became a national pastime. A federal government land office sold public lands on generous credit terms. Nearly all of Andrew Jackson’s wealth came from land speculation with borrowed money. Some setbacks he experienced in the process contributed to his hatred of the Eastern financial establishment.
State and federal legislation during this period tolerated or even encouraged easy provision of credit. During the “wildcat banking” era, lax regulation fomented a do-it-yourself expansion of the money supply by banks that could issue their own paper banknotes with only a tenuous link to the actual gold or silver in their control.
The result, of course, was an era between the War of 1812 and the Civil War that saw repeated financial scandals, bank failures and economywide financial and debt crises. Despite this, the economy grew strongly. Financial affairs were somewhat less turbulent in the decades after the Civil War, but the settling of the West was all done on credit to a degree that would have been impossible anywhere in Europe.
One important theme is that credit, broadly defined, is not as constrained by the money supply as economists traditionally assumed. We had an agricultural land price bubble from 1973 to 1981 in which seller-financing of farmland on contracts for deed played a major role. There did not have to be expanded farm mortgage lending by banks and other ag lenders for there to be an expansion of effective demand for farmland as long as many landowners were willing to create credit themselves by agreeing to installment sales.
Similarly, when I lived in inflationary Brazil 40 years ago, lack of availability of formal bank loans to buy automobiles or appliances did not prevent creation of nontraditional forms of credit. Car dealers would form “consorcios” in which potential buyers agreed to pay monthly amounts for periods of 36 or 48 months. But when buyers took possession of their car depended on a monthly drawing. Once 36 eager buyers were in a 36-month consortium, one car would be drawn for each month until all participants had gotten their Volkswagen or Ford.
It may seem like a long way from drawings for Beetles to the invention of new financial instruments like the “structured investment vehicle” or “credit default swap” by Wall Street — which contributed to the most-recent financial crisis — but both are manifestations of the fact that credit is complex, that it is often driven by nonrational forces, and that it is as hard to regulate as it is to define.