The Lesson Applied
Credit Diverts Production
Government “encouragement” to business is sometimes as much to be feared as government hostility. This supposed encouragement often takes the form of a direct grant of government credit or a guarantee of private loans.
The question of government credit can often be complicated, because it involves the possibility of inflation. We shall defer analysis of the effects of inflation of various kinds until a later chapter. Here, for the sake of simplicity, we shall assume that the credit we are discussing is noninflationary. Inflation, as we shall later see, while it complicates the analysis, does not at bottom change the consequences of the policies discussed.
A frequent proposal of this sort in Congress is for more credit to farmers. In the eyes of most congressmen the farmers simply cannot get enough credit. The credit supplied by private mortgage companies, insurance companies or country banks is never “adequate.” Congress is always finding new gaps that are not filled by the existing lending institutions, no matter how many of these it has itself already brought into existence. The farmers may have enough long-term credit or enough short-term credit but, it turns out, they have not enough “intermediate” credit; or the interest rate is too high; or the complaint is that private loans are made only to rich and well-established farmers. So new lending institutions and new types of farm loans are piled on top of each other by the legislature.
The faith in all these policies, it will be found, springs from two acts of shortsightedness. One is to look at the matter only from the standpoint of the farmers that borrow. The other is to think only of the first half of the transaction.
Now all loans, in the eyes of honest borrowers, must eventually be repaid. All credit is debt. Proposals for an increased volume of credit, therefore, are merely another name for proposals for an increased burden of debt. They would seem considerably less inviting if they were habitually referred to by the second name instead of by the first.
We need not discuss here the normal loans that are made to farmers through private sources. They consist of mortgages, of installment credits for the purchase of automobiles, refrigerators, TV sets, tractors and other farm machinery, and of bank loans made to carry the farmer along until he is able to harvest and market his crop and get paid for it. Here we need concern ourselves only with loans to farmers either made directly by some government bureau or guaranteed by it.
These loans are of two main types. One is a loan to enable the farmer to hold his crop off the market. This is an especially harmful type, but it will be more convenient to consider it later when we come to the question of government commodity controls. The other is a loan to provide capital—often to set the farmer up in business by enabling him to buy the farm itself or a mule or tractor, or all three.
At first glance the case for this type of loan may seem a strong one. Here is a poor family, it will be said, with no means of livelihood. It is cruel and wasteful to put them on relief. Buy a farm for them; set them up in business; make productive and self-respecting citizens of them; let them add to the total national product and pay the loan off out of what they produce. Or here is a farmer struggling along with primitive methods of production because he has not the capital to buy himself a tractor. Lend him the money for one; let him increase productivity; he can repay the loan out of the proceeds of his increased crops. In that way you not only enrich him and put him on his feet; you enrich the whole community by that much added output. And the loan, concludes the argument, costs the government and the taxpayers less than nothing, because it is “self-liquidating.”
Now as a matter of fact that is what happens every day under the institution of private credit. If a man wishes to buy a farm, and has, let us say, only half or a third as much money as the farm costs, a neighbor or a savings bank will lend him the rest in the form of a mortgage on the farm. If he wishes to buy a tractor, the tractor company itself or a finance company, will allow him to buy it for one-third of the purchase price with the rest to be paid off in installments out of earnings that the tractor itself will help to provide.
But there is a decisive difference between the loans supplied by private lenders and the loans supplied by a government agency. Each private lender risks his own funds. (A banker, it is true, risks the funds of others that have been entrusted to him; but if money is lost he must either make good out of his own funds or be forced out of business.) When people risk their own funds they are usually careful in their investigations to determine the adequacy of the assets pledged and the business acumen and honesty of the borrower.
If the government operated by the same strict standards, there would be no good argument for its entering the field at all. Why do precisely what private agencies already do? But the government almost invariably operates by different standards. The whole argument for its entering the lending business, in fact, is that it will make loans to people who could not get them from private lenders. This is only another way of saying that the government lenders will take risks with other people’s money (the taxpayers’) that private lenders will not take with their own money. Sometimes, in fact, apologists will freely acknowledge that the percentage of losses will be higher on these government loans than on private loans. But they contend that this will be more than offset by the added production brought into existence by the borrowers who pay back, and even by most of the borrowers who do not pay back.
This argument will seem plausible only as long as we concentrate our attention on the particular borrowers whom the government supplies with funds, and overlook the people whom its plan deprives of funds. For what is really being lent is not money, which is merely the medium of exchange, but capital. (I have already put the reader on notice that we shall postpone to a later point the complications introduced by an inflationary expansion of credit.) What is really being lent, say, is the farm or the tractor itself. Now the number of farms in existence is limited, and so is the production of tractors (assuming, especially, that an economic surplus of tractors is not produced simply at the expense of other things). The farm or tractor that is lent to A cannot be lent to B. The real question is, therefore, whether A or B shall get the farm.
This brings us to the respective merits ofA and B, and what each contributes, or is capable of contributing, to production. A, let us say, is the man who would get the farm if the government did not intervene. The local banker or his neighbors know him and know his record. They want to find employment for their funds. They know that he is a good farmer and an honest man who keeps his word. They consider him a good risk. He has already, perhaps, through industry, frugality and foresight, accumulated enough cash to pay a fourth of the price of the farm. They lend him the other three-fourths; and he gets the farm.
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.
Now it is to A, let us say, who has credit that the banker would make his loan. But the government goes into the lending business in a charitable frame of mind because, as we say, it is worried about
B. B cannot get a mortgage or other loans from private lenders because he does not have credit with them. He has no savings; he has no impressive record as a good farmer; he is perhaps at the moment on relief. Why not, say the advocates of government credit, make him a useful and productive member of society by lending him enough for a farm and a mule or tractor and setting him up in business?
Perhaps in an individual case it may work out all right. But it is obvious that in general the people selected by these government standards will be poorer risks than the people selected by private standards. More money will be lost by loans to them. There will be a much higher percentage of failures among them. They will be less efficient. More resources will be wasted by them. Yet the recipients of government credit will get their farms and tractors at the expense of those who otherwise would have been the recipients of private credit. Because B has a farm, A will be deprived of a farm. A may be squeezed out either because interest rates have gone up as a result of the government operations, or because farm prices have been forced up as a result of them, or because there is no other farm to be had in his neighborhood. In any case, the net result of government credit has not been to increase the amount of wealth produced by the community but to reduce it, because the available real capital (consisting of actual farms, tractors, etc.) has been placed in the hands of the less efficient borrowers rather than in the hands of the more efficient and trustworthy.
Credit Diverts Production
Section 2
The case becomes even clearer if we turn from farming to other forms of business. The proposal is frequently made that the government ought to assume the risks that are “too great for private industry.” This means that bureaucrats should be permitted to take risks with the taxpayers’ money that no one is willing to take with his own.
Such a policy would lead to evils of many different kinds. It would lead to favoritism: to the making of loans to friends, or in return for bribes. It would inevitably lead to scandals. It would lead to recriminations whenever the taxpayers’ money was thrown away on enterprises that failed. It would increase the demand for socialism: for, it would properly be asked, if the government is going to bear the risks, why should it not also get the profits? What justification could there possibly be, in fact, for asking the taxpayers to take the risks while permitting private capitalists to keep the profits? (This is precisely, however, as we shall later see, what we already do in the case of “nonrecourse” government loans to farmers.)
But we shall pass over all these evils for the moment, and concentrate on just one consequence of loans of this type. This is that they will waste capital and reduce production. They will throw the available capital into bad or at best dubious projects. They will throw it into the hands of persons who are less competent or less trustworthy than those who would otherwise have got it. For the amount of real capital at any moment (as distinguished from monetary tokens run off on a printing press) is limited. What is put into the hands of B cannot be put into the hands of A.
People want to invest their own capital. But they are cautious. They want to get it back. Most lenders, therefore, investigate any proposal carefully before they risk their own money in it. They weigh the prospect of profits against the chances of loss. They may sometimes make mistakes. But for several reasons they are likely to make fewer mistakes than government lenders. In the first place, the money is either their own or has been voluntarily entrusted to them. In the case of government-lending the money is that of other people, and it has been taken from them, regardless of their personal wish, in taxes. The private money will be invested only where repayment with interest or profit is definitely expected. This is a sign that the persons to whom the money has been lent will be expected to produce things for the market that people actually want. The government money, on the other hand, is likely to be lent for some vague general purpose like “creating employment”; and the more inefficient the work—that is, the greater the volume of employment it requires in relation to the value of the product— the more highly thought of the investment is likely to be.
The private lenders, moreover, are selected by a cruel market test. If they make bad mistakes they lose their money and have no more money to lend. It is only if they have been successful in the past that they have more money to lend in the future. Thus private lenders (except the relatively small proportion that have got their funds through inheritance) are rigidly selected by a process of survival of the fittest. The government lenders, on the other hand, are either those who have passed civil service examinations, and know how to answer hypothetical questions hypothetically, or they are those who can give the most plausible reasons for making loans and the most plausible explanations of why it wasn’t their fault that the loans failed. But the net result remains: private loans will utilize existing resources and capital far better than government loans. Government loans will waste far more capital and resources than private loans. Government loans, in short, as compared with private loans, will reduce production, not increase it.
The proposal for government loans to private individuals or projects, in brief sees B and forgets A. It sees the people into whose hands the capital is put; it forgets those who would otherwise have had it. It sees the project to which capital is granted; it forgets the projects from which capital is thereby withheld. It sees the immediate benefit to one group; it overlooks the losses to other groups, and the net loss to the community as a whole.
The case against government-guaranteed loans and mortgages to private businesses and persons is almost as strong as, though less obvious than, the case against direct government loans and mortgages. The advocates of government-guaranteed mortgages also forget that what is being lent is ultimately real capital, which is limited in supply, and that they are helping identified B at the expense of some unidentified A. Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.
Credit Diverts Production
Section 3
We remarked at the beginning of this chapter that government “aid” to business is sometimes as much to be feared as government hostility. This applies as much to government subsidies as to government loans. The government never lends or gives anything to business that it does not take away from business. One often hears New Dealers and other statists boast about the way government “bailed business out” with the Reconstruction Finance Corporation, the Home Owners Loan Corporation and other government agencies in 1932 and later. But the government can give no financial help to business that it does not first or finally take from business. The government’s funds all come from taxes. Even the much vaunted “government credit” rests on the assumption that its loans will ultimately be repaid out of the proceeds of taxes. When the government makes loans or subsidies to business, what it does is to tax successful private business in order to support unsuccessful private business. Under certain emergency circumstances there may be a plausible argument for this, the merits of which we need not examine here. But in the long run it does not sound like a paying proposition from the standpoint of the country as a whole. And experience has shown that it isn’t.
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