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.
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.
(For the rest of my chapter, click the link.)