CHAPTER VII

CREDIT

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53. Nature of credit.-The term "credit" is used with a great variety of meanings. A man is said to have good credit if he has the reputation among his business associates of paying his debts promptly when due. To give credit is to accept another's promise to pay in exchange for a valuable consideration. To say that a firm gets a "line of credit" at a bank or with another business house means that it has the right to borrow or to get goods up to a certain amount by agreeing to pay sometime in the future. Credit may be broadly defined as "the power to get goods in exchange by giving a promise or contract to deliver an equivalent at some future time." 2 In short, credit is a promise to pay money.

There has been much discussion as to whether confidence or futurity is the essential thing in credit; and as to whether credit is based on money or on goods. It seems clear that "futurity is the distinctive factor in credit, while confidence lies at the basis of the granting of credit.''3 The time element enters into all credit transactions, yet the essence of credit is confidence on the part of the creditor in the debtor's willingness and ability to pay his debt. In certain kinds of credit transactions, as, for example, the

1 See Prendergast: Credit and Its Uses, pp. 8-11.

2 Johnson: Money and Currency, p. 4. For other definitions see Laughlin: Principles of Money, p. 72.

3. Hagerty: Mercantile Credit, p. 8.

purchase and sale of goods on credit, confidence may rest upon the character and business ability of the borrower. In other types of credit transactions, as call loans or mortgage loans, confidence rests more upon the securities or property pledged than upon the borrower's personal integrity-yet the element of confidence is present in some form in all such transactions. As to whether credit is based on money or goods, it need only be said that the promise to pay in the future involved in a credit transaction is usually expressed in terms of money, and is "completed by the payment of money, credit money, or a title to money.'

The most important service of credit is to facilitate the transfer of capital and thus to promote the production of wealth. But it must be understood that credit is not itself either capital or wealth. Wealth consists of economic goods and capital consists of economic goods used in the production of wealth. Now credit is not "a thing or commodity, nor does it create anything. No more wealth, no more capital, no more goods, exist after credit is given than before."2 If capital is in the hands of the borrower, it is withdrawn from the lender. Credit, then, is merely the agency of transfer. But to the extent that credit transfers capital from the hands of the passive owners to the borrower or enterpriser who will employ it in larger production, it increases the usefulness of capital.

54. Classes of credit.-Credit may be classified in a variety of ways. A common and serviceable classification divides credit into five kinds: personal, commercial, banking, agricultural, public and investment credit. In a broad sense all credit is financial, since it involves the payment of money or money's worth, but the foregoing classification will be helpful in illustrating the different kinds of credit instruments to which each class of credit gives rise. Though in this book we are concerned primarily with banking and

1 Hagerty, p. 15.

2 Johnson, p. 36.

commercial credit it will be well to discuss the other kinds briefly to show their relation to these two.

Public credit is the power of a government, nation, state, county, or city, to secure funds in exchange for its promise to pay in the future. This promise takes the form ordinarily of bonds which are sold to bankers, investment houses and individuals. Government or municipal bonds, which are simply promises to pay money, are usually not protected by the pledge or deposit of any specified property; the purchaser rests upon faith in the government to pay its debts. Sometimes, however, the credit of a government becomes so weakened because of heavy expenditures for war or other purposes that it finds it necessary to pledge certain property or income as a guarantee that it will meet its obligations. Thus, for example, the Japanese government was compelled to borrow vast sums of money during the war with Russia in 1905, and one of its loans was secured by a charge on the revenues of the tobacco monopoly. The rate of interest on government bonds is a general index of the government's credit. Government and municipal bonds are frequently used by the owners as collateral to strengthen their individual credit when they wish to borrow funds at the bank.

National governments use their credit also by the issue of government notes or paper money, as in the case of our greenbacks. Many governments have abused their credit by issuing great quantities of irredeemable paper currency and, generally, humiliating results have followed.

Investment or capital credit is represented by bonds and stocks of incorporated businesses and by real-estate mortgages and bonds. Real-estate mortgages have always been a favorite form of investment. Vast amounts of money are thus invested by savings banks, trust companies, insurance companies, building and loan associations, and other organizations which act in the capacity of trustee or custodian of funds.

Agricultural credit instruments take the form of notes accompanied by mortgages on the land, farm implements,

or the crops. Most European countries have long had mortgage banks and systems of agricultural credit which have provided the farming classes with fair credit facilities. Until recently scant attention has been given to agricultural credit in the United States, but the Federal Farm Loan Act1 of 1916 is intended to provide the farmer with credit facilities comparable with those enjoyed by the manufacturer and the merchant.

In the modern business world the corporation has proved to be the most advantageous form of business organization for large undertakings. Railroad and public utility companies, manufacturing concerns, mercantile enterprises, banking and insurance companies-these and many other types of business organizations operate under the corporate form. These corporations get a large proportion of their capital through the sale of stocks and bonds to individual investors. Bondholders have a preferred claim to the earnings and assets of the company, and, usually, their investments are protected by a mortgage upon the property of the corporation. A stockholder is virtually a partner in the corporation, sharing its gains and its losses, and having a voice in its management. A corporation is able to get capital credit from a great variety of investors through the sale of its shares of stock. In most types of corporations. stockholders are responsible for the debts of the company only to the amount of their holdings. Then, again, they are free to leave at any time simply by selling their stock to someone else. Because of these and other advantages, the corporation attracts capital funds from many sources.

Corporation bonds are issued usually for long periods, varying from five to fifty years or longer. Sometimes, however, when money rates are high, corporations which are in urgent need of funds issue "short-term notes" running from one to three or five years, rather than contract to pay the high rates for a long period of years which would be the case if they issued bonds. When a corporation issues these short-term notes instead of bonds it is with the 1 See p. 150 for discussion of this Act.

expectation, usually, that before the notes mature it will be possible to sell bonds at a lower rate of interest or at a better price than when the notes were issued. As already noted, corporation bonds are generally issued against a mortgage which gives the bondholders title to some property. Short-term notes, however, have no such protection, but are issued on the general credit of the corporation.

55. Personal credit.-Personal or individual credit is the power of an individual to secure something valuable in the present in exchange for a promise to pay in the future. Because personal credit is sought chiefly for purposes of consumption, it is sometimes called consumption credit; but it is used also to secure credit for purposes of production, to procure professional services of various kinds, and to borrow money. Of all kinds of credit, personal credit is the most common and widespread. All classes of people give or receive personal credit at some time and to some degree. Wage-earners extend credit to their employers by working for a day, a week or a month before receiving their pay; lawyers, physicians and other professional classes give credit to their clients or patients until the latter are ready to pay their bills; grocery stores and shops open "charge" accounts with their customers; manufacturers sell goods to wholesalers on "time," and these in turn sell to retailers on time, and so on. Personal credit ramifies through every department of our modern life. As we shall see, it is often very closely related to mercantile and banking credit. The chief elements in credit are character, capacity or business ability, and capital or collateral. Of these elements, character is the most important in personal credit. Multitudes of people without capital or known business ability are constantly getting credit because of the confidence which the extenders of credit have in their honesty and integrity.

The simplest of all forms of credit is book credit-having things "charged." In rural communities where the farmer's return for his crops is received only at long intervals, book credit, his credit at the country store, tides him over