Tuesday, October 28, 2008

Capitalism's Two Kinds of Credit

Virtually everyone agrees the global economy is in the grip of a credit crisis. Now might be a good time to draw a distinction between the two kinds of credit within capitalism.

One is essential, the other is dispensible. It's best not to confuse the two.

The indispensible credit is commercial credit, in which entrepreneurs and traders establish letters of credit, borrow capital or sell stakes to fund voyages, purchase tradable commodities, fund new ventures, etc.

This has been so for at least a thousand years, stretching back into the pre-capitalist middle ages. There is really no way to fully comprehend this without reading this astonishing trilogy by French historian Fernand Braudel, Civilization and Capitalism, 15th to 18th Centuries. Longtime readers have been hectored on numerous occasions to check out at least one of the volumes:
The Structures of Everyday Life (Volume 1)
The Wheels of Commerce (Volume 2)
The Perspective of the World (Volume 3)

Here is but one brief example from Volume 3 of the centrality of commercial credit to the system of commerce we call Capitalism, as it operated in Venice in the 15th century:

But the commercial loan was another matter. This was an indispensable instrument of trade, and its interest rates, though high, were not regarded as usurious since they were more or less the same as those charged by bankers. Nine times out of ten, this kind of loan was associated with a partnership. These made their first appearance in at least 1072-1073 and were soon found in two versions.

At the end of the (trading) voyage when the accounts were settled, the traveller, after repaying the sum originally advanced, kept one quarter of the profits, the rest going to the 'capitalist.'
Alternatively there was the bilateral agreement whereby the lender put up 3/4 of the sum required and the trader/traveller contributed not only his work but 1/4 of the capital. In this case profits were split 50-50. This but one example of a hugely complex web of credit which extended from Lyon in France to Antwerp in the north and south to Venice, to name but three of many cities with far-reaching credit and trade arrangements.

It is impossible to summarize these sprawling networks of credit, settlement, stock shares, loans and partnerships in early capitalism, but three conditions required such arrangements: time, distance and the paucity of gold available for currency.

Prior to the Spanish discovery and conquest of the New World and its vast wealth of silver and gold, there simply wasn't enough gold in Europe to "grease" the immense trade which stretched through the Muslim world all the way to China and southeast Asia. The Chinese and Indians only accepted gold or silver, and so Europe was always "short" of specie/precious metals to act as currency.

As a result, lines of credit which could be settled at the end of the huge trade fairs in Lyon and elsewhere were essential.

Long trading voyages to India, Indonesia (Dutch East Indies or Spice Islands) and China took several years, and the initial capital required was large. Shares of the voyage were thus split amongst investors and lenders, and the great dangers of the sea (i.e. if the ship sank the investors/owners lost their stake) brought about insurance and stock markets where shares of the voyage could be traded "marked to market," so an overdue vessel's shares would depreciate as everyone feared it was lost and the shares rendered worthless.

But if the vessel came through with its rich cargo, the investors and owners stood to reap stupendous profits. Big risks were taken to gain big profits, and money was loaned and partnerships formed to spread the risk.

Without commercial credit, trade grinds to a halt--whether the date is 1706 or 2008.

Now as commercial credit has been severely impaired, global trade and production are indeed threatened on many fronts. Frequent contributor Harun I. sent in this Bloomberg story about agricultural production being at risk of declines due to the tightening of credit to farmers:

Farm-Credit Squeeze May Cut Crops, Spur Food Crisis:
The credit crunch is compounding a profit squeeze for farmers that may curb global harvests and worsen a food crisis for developing countries.

Global production of wheat, the most-consumed food crop, may drop 4.4 percent next year, said Dan Basse, president of AgResource Co. in Chicago, who has advised farmers, food companies and investors for 29 years. Harvests of corn and soybeans also are likely to fall, Basse said. Here we see "unintended consequences" of the credit crisis. Commercial credit is the lifeblood of capitalism, be it the Version1.0 of 1072 or V1.3 in 1381 or V1.9 in 1706 or V2.11 in 2008. The freezing-up of commercial credit and settlement is truly a crisis with long-term negative consequences.

The second form of credit in modern capitalism was never an essential feature of classic capitalism: lending to consumers to buy end-products. If you wanted to buy Chinese silks or pottery at the Lyon Fair in 1593, you paid in silver, baby, or with "commercial paper" which settled out after the fair against debts owed to you by other traders.

Demand was based on cash, not loans; supply was based on loans and credit, but those lines of credit were always settled at the end of the Fair or the voyage.

In the Great Depression (of the 1930s, not the current one), retailers extended credit to customer directly. Both of my parents report that bicycles were purchased on a $1-per-week plan that was paid to the retailer, not a bank; the retailer extended this credit because otherwise he/she might not sell enough bicycles for cash to stay in business.

We have now arrived at a bizarre, unsustainable version of capitalism in which only the most trivial purchases are paid in cash; everything of substance is paid with credit which may or may not be "settled" in any time frame.

Once this credit is pulled/constricted, all "demand" which was based not on cash but on debt/credit dries up and blows away in the lightest breeze. That is our situation today in a vulnerable economy dependent on debt-fueled consumer "demand" for fully 70% of all economic activity.

In other nations, even houses are bought with cash or perhaps 50% in cash and 50% mortgages. Autos are purchased for cash, and home mortgages are for perhaps 10 or 15 years--that is, they are intended to be paid off, not carried forever without a settlement date.

The point is simply this: we need to distinquish between commercial credit which is an essential feature of Capitalism and thus must be restored in both availability and "settlement," and consumer credit which can and should be allowed to wither away to its "natural" state: rare, costly, and settled by a date measured in months, not decades.

Capitalism with a capital C does not require consumers/end-users have access to unlimited credit with no settlement date, but it does require commercial credit which enables trade across both time and distance.

For an alternative to a debt-driven consumer, please consider The Richest Man in Babylon which was recommended to me by correspondent Alberto R.

Hopefully you can find the Braudel series and this book at your local library; if not, owning a used copy will offer much insight, even on re-reading.

NOTE: Thank you, readers, for your many wonderful comments on yesterday's entry. I will try to answer each email as time permits.

Thank you, Charles U. ($20), (oh ye of fab first name :-) for your exceedingly gracious donation to this site. I am greatly honored by your support and readership.

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