Chapter 6: Credit Diverts Production
He that is surety for a stranger shall smart for it: and he that hateth suretiship is sure (Proverbs 11:15).
The older term, surety, is not widely used today. The term today is this: co-sign. The warning is still as valid today as it was in the days of Solomon. Do not co-sign a note for a stranger. But Solomon went beyond this. He recommended that nobody co-sign a note for a friend, either (Proverbs 6:1-5).
When you co-sign a note, you become the collateral for a loan. A lender has decided that the person who requests a loan has insufficient collateral. The borrower has no way to pay back the loan, should his plans for the borrowed money go awry. He has insufficient marketable assets in reserve. In other words, he has a low credit rating. The lender does not want to make the loan on this basis. So, the prospective borrower seeks out somebody who does have collateral, and who does have a good credit rating. He asks this person to co-sign the loan. So, if he defaults on the loan, the creditor will then come to the solvent friend of the now-insolvent debtor. He will collect the money owed to him from the solvent friend.
Solomon recommended that nobody co-sign a note for a friend. Obviously, if it is a bad idea to co-sign a note for friend, it is an even worse idea to co-sign for a stranger.
It should be clear from this pair of proverbs that credit diverts production. Productive capital is shifted from one investment to another investment. The would-be borrower did not have sufficient credit to warrant this shift of investment. Only after his solvent friend co-signed the note was the creditor willing to divert production, meaning capital assets used in production, from his previously highest-ranked investment opportunity to the new one. He would not have diverted his capital, had the solvent individual not been willing to co-sign the note. The signature of the friend lowered the risk of default for the creditor. This moved the loan into first place on the creditor's scale of investment opportunities.
With this in mind, let us consider the economics of government loans to businesses.
Who are the owners, and what do they own?
There are two owners: the lender and the borrower. The lender owns money. This is a capital asset. It could be used for consumption purposes, but the owner is a capitalist. He prefers to put his money to use in order to gain even more money later on. He looks for borrowers with good credit ratings to lend to. Because the lender owns money, what he owns is easy to see and understand. What is not easy to see or understand is what the borrower owns: credit worthiness (at some rate of interest). This is the thing not seen. Henry Hazlitt put it this way:
There is a strange idea abroad, held by all monetary cranks, that credit is something a banker gives to a man. Credit, on the contrary, is something a man already has. He has it, perhaps, because he already has marketable assets of a greater cash value than the loan for which he is asking. Or he has it because his character and past record have earned it. He brings it into the bank with him. That is why the banker makes him the loan. The banker is not giving something for nothing. He feels assured of repayment. He is merely exchanging a more liquid form of asset or credit for a less liquid form. Sometimes he makes a mistake, and then it is not only the banker who suffers, but the whole community; for values which were supposed to be produced by the lender are not produced and resources are wasted.
In any economic transaction, there is an exchange. The exchange is an exchange of ownership, either permanently or temporarily. In this case, it is a temporary exchange of ownership. The owner of money lends money, meaning the use of money, to a borrower. What does he receive in exchange? He receives a promise of repayment of the original loan, plus an additional payment, later on. The rate of interest -- the price of the loan -- is in the contract. So is the length of the loan: the deadline for repayment.
The lender knows better than to seek something for nothing. So, what does he seek? He seeks a written promise of repayment. He seeks it from someone who possesses good credit. The borrower's credit rating is the asset that undergirds the written promise to repay. Therefore, the borrower is someone with capital. This capital is his reputation as a reliable participant in the economy.
Because both of the participants in the exchange are owners of capital, this makes an exchange economically rational for both of them. Because each of them is an owner, each of them has legal sovereignty to make the exchange. Each of them possesses ownership rights in his respective forms of capital. Property rights mean immunity from coercion, either by private citizens or by the state. The threat is this: the state may revoke some or all of these ownership rights.
Because each of the participants has the right to make an exchange, each of them can act to achieve his goals. Each of them seeks to improve his situation. The owner of money wants more money in the future. The owner of good credit has some use for the money during a specified period of time. He therefore borrows the money, using it in whatever way he chooses, on this basis: he will repay the creditor in the future. This enables a borrower to buy either consumer goods or production goods. He is able to use this money to achieve his goals. He then makes bids on assets.
If he is a capitalist, he buys capital equipment, raw materials, labor services, and perhaps land where he can operate a business. He does so in the hope that he will be able to produce a product or service that will be valuable to customers in the future. He thinks they will be willing to pay him more than he has paid to buy or rent the goods and services necessary to produce consumer goods or services. In other words, he buys low and sells high. The loan that he receives from the capitalist enables him better to serve the demands of future customers. If he is correct in his plans, he will reap a profit, and he will then repay the loan with interest. The lender gets what he wants. The borrower gets what he wants. Customers get what they want. The original investment leads to greater production, which in turn leads to greater customer satisfaction.
In each case, the asset owner acts on behalf of future customers, i.e., money owners. Each asset owner is a representative, economically speaking, of these future customers. Of course, these future customers may decide to become future non-customers. They retain the legal right not to purchase goods and services. But, from an economic standpoint, the capitalists must operate as representative agents for future customers. Because customers have money, and money is the most marketable commodity, customers are in authority.
Into this voluntary series of voluntary arrangements comes the state. The state taxes individuals and businesses in order to gain revenue. It also borrows money from lenders. In some cases, it borrows money from central banks, which create new money out of nothing in order to buy IOU's from the government.
An agency of the state then makes money available to businesses. It makes loans at a rate of interest that is lower than what the borrower would have to pay in the private capital markets. There is a reason why the borrower would have to pay more in the private capital markets: he has a low credit rating. This is another way of saying that he is a higher risk borrower than other borrowers in the market for loans. Bankers and other potential lenders have examined this person's past credit, and they have determined that this person is a bad credit risk at a low rate of interest. In order to make a loan viable, he must pay a higher rate of interest, in order to compensate the lenders for the higher risk of dealing with him. He then goes shopping for a loan from the government.
An agency of the state then determines that this borrower deserves a loan. The state takes some of the money that it has confiscated from taxpayers, and it turns this money over to the borrower. It does so at a below-market rate of interest. Private lenders would have charged the borrower more, given his low credit rating.
The state agency does this for a reason. Such loans are popular with voters. Also, the state agency does not put its own money at risk. It will get more money in the next fiscal year. It has a guaranteed source of money for as long as the politicians decide that it is good politics to fund the agency with more confiscated money. In other words, the agency does not make the determination based on economics; it makes the determination based on politics.
We never get something for nothing. Therefore, we should follow the money. We should search for the things not seen.
Here is what is not seen by the general public. First, money that would otherwise have been available to professional lenders to lend to borrowers with high credit ratings is not available to the lenders, because it has been confiscated by the state. Second, those borrowers who would have obtained loans, based on their high credit ratings, are not able to obtain these loans, because the money has been funneled from the government tax-collecting agency to the agency that makes loans available to high-risk borrowers at below-market interest rates.
Then there are the future customers of those borrowers who would have used the borrowed money to go into production. They do not go into production, because they did not gain access to a loan. Because there was less money available to private lenders, because the government had confiscated the money, the lenders are not in a position to lend out money to otherwise qualified borrowers. The future customers of these borrowers pay the price. They do not perceive that they pay a price, because they do not see the goods or services that are not offered to them for sale. These are things not seen.
Because the borrowers are higher-risk borrowers, there is a higher rate of default on these loans. Who makes payment on these defaulted loans? Who has co-signed the notes? The taxpayers. They do not know that they have co-signed the notes, but they have. The government agency that lent the money, which was confiscated from the taxpaying public, does not pursue the now-bankrupt borrowers. They write off the loans. This is wasted capital. But then, sure as clockwork, the agency has these lost funds replenished by politicians in the next fiscal year. The losers are the taxpayers. The lending agencies co-signed the notes on behalf of the taxpayers, but without the knowledge of the taxpayers. The taxpayers pay the agencies in the next fiscal year.
Because customers face a reduced range of choices for their money, they are poorer. They do not perceive that they are poorer, because they do not see the things not seen: the goods and services that would otherwise have been offered to them, but which were not produced, precisely because the government had extracted wealth from potential lenders, and because the government then loaned the confiscated money to producers without experience, and without good credit, but who qualified in terms of political criteria rather than economic criteria. They were the right sort of borrowers from a political standpoint.
Some customers are benefited, of course. These are the customers of the companies that did not go bankrupt after they borrowed money from the government agency. These customers have their wants satisfied, but had the government not confiscated the money from the taxpayers, these customers would have had to pay more for whatever it is they wanted to buy. This is because there would have been fewer goods and services offered to them. The entrepreneurs and capitalists who would have borrowed the money in the private markets, but who could not do so, would have produced a different set of products and services. They would have served other customers.
So, there is a redistribution of wealth between certain classes of customers. This is not perceived by the customers, nor is it perceived by the politicians, but this is the inevitable outcome of the initial intervention into the market by the state. It leads to reduced production, and it also leads to the subsidizing of certain groups of customers. These customers are subsidized by those customers who did not find the goods and services they wanted at prices they were willing to pay, because of the original intervention into the marketplace
The result of the intervention, as always, is reduced economic growth. Those producers in the marketplace who have good credit ratings, and who were willing and able to borrow money from lenders, do not get access to the money they need in order to go into production. This reduces production.
At the same time, those borrowers who qualified politically for the loans from the government did go into production, but because they were higher credit risks, the rate of default exceeded those rates of default common among private lenders. This capital is wasted. It is not lent out by the government agency the next year, because it never comes back to the government agency. Instead, the borrower defaulted on the loan.
Government-supplied credit diverts production from high-output producers, who would otherwise have met the demands of customers. It shifts production to high-risk producers. This subsidizes the customers of those high-risk producers who do not go out of business and default on their loans. In other words, capital is shifted by government intervention from high-output, low-risk producers to lower-output, higher-risk producers. This leads to reduced production. It leads to reduced rates of economic growth. It leads to a reduced supply of capital. It therefore leads to reduced per capita wealth in the society.
The existence of various kinds of subsidies to businesses, especially export-oriented businesses, is an old story. It goes back to mercantilism in the 16th century. Adam Smith did his best to refute the errors of mercantilism in 1776, but the errors still persist.
Generally, the big money in credit diversion is associated with big businesses. But the justification politically always is the help that government loans give to small businesses. This is comparable to the justification of farm subsidies. The overwhelming percentage of the farm subsidies go to large-scale agribusiness organizations, but the justification is always in favor of saving small farmers, who constitute about 2% of the American population. Big businesses are much better at lobbying than small businesses are. They have more money to spend.
The voters hear about loans to small businesses, so they accept the idea of government loans to small businesses. This provides the political cover. The thing not seen politically is this: most of the money flows to big businesses.
The government becomes the literal co-signer of the notes, so big businesses then borrow on the credit of the national government. The lenders benefit, because they have what they believe to be a solvent co-signer of the notes. Big banks, big businesses, and big government siphon off money from the general public, and the agency of this confiscation does so by co-signing the notes.
Solomon knew better.
For documentation, go here: http://bit.ly/CEIOL-Doc-6All of the chapters are here: http://bit.ly/CEIOL