The Theory of Business Enterprise/Chapter 5
The Use of Loan Credit

Credit serves two main uses in the regular course of such
business as is occupied with the conduct of industry. - (a) that
of deferred payments in the purchase and sale of goods - book
accounts, bills, checks, and the like belong chiefly under this
head; and (b) loans or debts - notes, stock shares,
interest-bearing securities, deposits, call loans, etc., belong
chiefly here. These two categories of credit extension are by no
means clearly distinct. Forms of credit which commonly serve the
one purpose may be turned to the other use; but the two uses of
credit are, after all, broadly distinguishable. For many purposes
of economic theory such a distinction might not be serviceable,
or even practicable; it is here made merely for present use. It
is chiefly with credit of the latter class, or rather with credit
in so far as it is turned to use for the latter purpose, that
this inquiry is concerned.

Suppose due credit arrangements have already been made - in
the way of investments in stocks, interest-bearing securities and
the like - such as to place the management of the industrial
equipment in competent hands. This supposition is not a violent
one, since a condition roughly approximating to this prevails in
any quiescent period of industry when there is no appreciable
depression. Under these "normal" conditions, the capital invested
in any given industrial venture is turned over within a certain,
approximately definite, length of time. The length of time
occupied by the turnover may vary from one establishment to
another, but in any given case the length of the turnover is one
of the important factors that determine the chances of gain for
the business concern in question. Indeed, if the general
conditions of the trade and of the market are given, the two
factors which determine the status and value of a given sound
concern, as seen from the business man's standpoint, are the
magnitude of the turnover and the length of time it occupies.
 
The business man's object is to get the largest aggregate
gain from his business. It is manifestly for his interest, as far
as may be, to shorten the process out of which his earnings are
drawn,(1*) or, in other words, to shorten the period in which he
turns over his capital. If the turnover consumes less than the
time ordinarily allowed in the line of industry in which he is
engaged, he gains more than the current rate of profits in that
line of business, other things equal; whereas he loses if the
turnover takes more than the normal time. This fact is forcibly
expressed in the maxim, "Small profits and quick returns." There
are two chief means of shortening the interval of the turnover,
currently resorted to in industrial business. The first is the
adoption of more efficient, time-saving industrial processes.
Improvements of industrial plant and industrial processes having
this in view are gaining in importance in the later developments
of business, since a closer attention is now given to the time
element in investments, and great advances have been made in this
direction.(2*) A second expedient for accelerating the rate of
turnover is the competitive pushing of sales, through larger and
more urgent advertising and the like. It is needless to say that
this means of accelerating business also receives due attention
at the hands of modern business men.

But the magnitude of the turnover, "the volume of business,"
is of no less consequence than its rapidity. It is, of course, a
trite commonplace that the earnings of any industrial business
are a joint function of the rate of turnover and the volume of
business.(3*) The business man may reach his end of increased
earnings by either the one or the other expedient, and he
commonly has resource to both if he can. His means of increasing
the magnitude of the turnover is a resort to credit and a close
husbanding of his assets. He is under a constant incentive to
increase his liabilities and to discount his bills receivable.
Indebtedness in this way comes to serve much the same purpose, as
regards the rate of earnings, as does a time-saving improvement
in the processes of industry.(4*) The effect of the use of credit
on the part of a business man so placed is much the same as if
his capital had been turned over a greater number of times in the
year. It is accordingly to his interest to extend his credit as
far as his standing and the state of the market will admit.(5*)

But on funds obtained on credit the debtor has to pay
interest, which, being deducted from the gross earnings of the
business, leaves, as net gain due to his use of credit, only the
amount by which the increment of gross earnings exceeds the
interest charge. This sets a somewhat elastic limit to the
advantageous use of loan credit in business. In ordinary times,
however, and under capable management, the current rate of
business earnings exceeds the rate of interest by an appreciable
amount; and in times of ordinary prosperity, therefore, it is
commonly advantageous to employ credit in the way indicated.
Still more so in brisk times, when opportunities for earnings are
many and promise to increase. To turn the proposition about, so
as to show the run of business motives in the case: whenever the
capable business manager sees an appreciable difference between
the cost of a given credit extension and the gross increase of
gains to be got by its use, he will seek to extend his credit.
But under the regime of competitive business whatever is
generally advantageous becomes a necessity for all competitors.
Those who take advantage of the opportunities afforded by credit
are in a position to undersell any others who are similarly
placed in all but this respect. Speaking broadly, recourse to
credit becomes the general practice, the regular course of
competitive business management, and competition goes on on the
basis of such a use of credit as an auxiliary to the capital in
hand. So that the competitive earning capacity of business
enterprises comes currently to rest on the basis, not of the
initial capital alone, but of capital plus such borrowed funds as
this capital will support.

The competitive rate of earnings is brought to correspond
with this basis of operation; the consequence being that under
such competitive employment of credit the aggregate earnings of
an enterprise resting on a given initial capital will be but
slightly larger than it might have been if such a general
recourse to credit to swell the volume of business did not
prevail. But since such use of credit prevails generally, a
further consequence is that any concern involved in the open
business competition, which cannot or does not take recourse to
credit to swell its volume of business, will be unable to earn a
"reasonable" rate of profits. So that the general practice drives
all competitors to the use of the same expedient; but since the
advantage to be derived from this expedient is a competitive
advantage only, the universality of the practice results in but a
slight, if any, increase of the aggregate earnings of the
business community. Borrowed funds afford any given business
concern a differential advantage as against other competitors;
but it is, in the main, a differential advantage only. The
competitive use of such funds in extending business operations
may, incidentally, throw the management of some portion of the
industrial process into more competent or less competent hands.
So far as this happens, the credit operations in question and the
use of the borrowed funds may increase or diminish the output of
industry at large, and so may affect the aggregate earnings of
the business community. But, apart from such incidental shifting
of the management of industry to more competent (or less
competent) hands, this competitive use of borrowed funds has no
aggregate effect upon earnings or upon the industrial output.

The current or reasonable rate of profits is, roughly, the
rate of profits at which business men are content to employ the
actual capital which they have in hand.(6*) A general resort to
credit extension as an auxiliary to the capital in hand results,
on the whole, in a competitive lowering of the rate of profits,
computed on capital plus credit, to such a point as would not be
attractive to a business man who must confine himself to the
employment of capital without credit extension. On an average, it
may be said, the aggregate earnings of the aggregate capital with
credit extension are but slightly greater than the aggregate
earnings of the same capital without credit extension would be in
the absence of a competitive use of credit extension. But under
modern conditions business cannot profitably be done by any one
of the competitors without the customary resort to credit.
Without the customary resort to credit a "reasonable" return
could not be obtained on the investment.

To the extent to which the competitive recourse to credit is
of the character here indicated - to the extent to which it is a
competitive bidding for funds between competent managers - it may
be said that, taken in the aggregate, the funds so added to
business capital represent no material capital or "production
goods." They are business capital, only. they swell the volume of
business, as counted in terms of price, etc., but they do not
directly swell the volume of industry, since they do not add to
the aggregate material apparatus of industry, or alter the
character of the processes employed, or enhance the degree of
efficiency with which industry is managed.

The "buoyancy" which a speculative inflation of values gives
to industrial business may indirectly increase the material
output of industry by enhancing the intensity with which the
industrial process is carried on under the added stimulus; but
apart from this psychological effect the expansion of business
capital through credit extension has no aggregate industrial
effect. This secondary effect of credit inflation may be very
considerable and is always present in brisk times. It is commonly
obvious enough to be accounted the chief characteristic of a
period of "prosperity." For a theory of industry this indirect
effect of credit inflation would be its main characteristic, but
for a theory of business it occupies the place of a corollary
only.

To the view set forth above, - that borrowed funds do not
increase the aggregate industrial equipment, - the objection may
present itself that all funds borrowed represent property owned
by some one (the lender or his creditors), and transferred, in
usufruct, by the loan transaction to the borrower; and that these
funds can, therefore, be converted to productive uses, like any
other funds, by drawing into the industrial process, directly or
indirectly, the material items of wealth whose fluent form these
funds are.(7*) The objection fails at two points: (a) while the
loans may be covered by property held by the lender, they are not
fully covered by property which is not already otherwise engaged;
and even if such were the case, it would (b) not follow that the
use of these funds would increase the technical (material) outfit
of industry.

As to the first point (a): Loans made by the financial houses
in the way of deposits or other advances on collateral are only
to a fractional extent covered by liquid assets;(8*) and anything
but liquid assets is evidently beside the point of the present
question. An inconsiderable fraction of these loans is
represented by liquid assets. The greater part of the advances
made by banking houses, for instance, rest on the lender's
presumptive ability to pay eventually, on demand or at maturity,
any claims that may in the course of business be presented
against the lender on account of the advances made by him. It is
a business truism that no banking house could at a moment meet
all its outstanding obligations.(9*) A necessary source of
banking profits, e.g., is a large excess of the volume of
business over reserves.

As to (b): Another great part of the basis of such loans is
made up of invested funds and collateral held by the lender.
These at the same time are much of the basis on which rests the
lender's presumptive ability to pay claims presented. But these
investments, in industry or real estate, in interest-bearing
securities and collateral of whatever description, represent
future income of the lender's debtors (as, e.g., government and
municipal securities), or property which is already either
engaged in the industrial process or tied up in forms of wealth
(as, e.g., real estate) which do not lend themselves to
industrial uses. Loans obtained on property which has no present
industrial use, which cannot in its present form or under
existing circumstances be employed in the processes of industry
(as, e.g., speculative real estate), or loans on property which
is already engaged in the industrial process (as, e.g., stocks,
industrial plant, goods on hand, real estate in use),(10*)
represent, for the purpose in hand, nothing more substantial than
a fictitious duplication of material items that cannot be drawn
into the industrial process. Therefore such loans cannot, at
least not directly, swell the aggregate industrial equipment or
enhance the aggregate productivity of industry; for the items
which here serve as collateral are already previously in use in
industry to the extent to which they can be used. Property of
these kinds - what is already in use in industry and what is not
of use for industrial purposes - may be "coined into means of
payment," and so may be made to serve as additional pecuniary
(business) capital, but such property is mechanically incapable
of serving as additional material (industrial) capital. To a very
considerable extent the funds involved in these loans, therefore,
have only a pecuniary (business) existence, not a material
(industrial) one; and, so far as that is true, they represent, in
the aggregate, only fictitious industrial equipment. Even such
inconsiderable portion of them, however, as represents metallic
reserves also adds nothing to the effective material apparatus of
industry; since money as such, whether metallic or promissory, is
of no direct industrial effect; as is evident from the well-known
fact that the absolute quantity of the precious metals in use is
a matter of no consequence to the conduct of either business or
industry, so long as the quantity neither increases nor decreases
by an appreciable amount. Nummus nummum non parit.

So that all advances made by banking houses or by other
creditors in a like case, - whether the advances are made on
mortgage, collateral or personal notes, in the form of deposits,
note issues, Or. what not; whether they are taken to represent
the items of property covered by the collateral, the cash
reserves of the banks, or the general solvency of the creditor or
debtor, - all these "advances" go to increase the "capital" of
which business men have the disposal; but for the material
purposes of industry, taken in the aggregate, they are purely
fictitious items.(11*) Cash loans (such as savings-bank deposits
(12*) and the like) belong in the same category. All these
advances afford the borrower a differential advantage in bidding
against other business men for the control and use of industrial
processes and materials, they afford him a differential advantage
in the distribution of the material means of industry; but they
constitute no aggregate addition to the material means of
industry at large. Funds of whatever character are a pecuniary
fact, not an industrial one; they serve the distribution of the
control of industry only, not its materially productive work.

Loan credit in excess of what may serve to transfer the
management of industrial materials from the owner to a more
competent user - that is to say, in so far as it is not, in
effect, of the nature of a lease of industrial plant - serves, on
the whole, not to increase the quantity of the material means of
industry nor, directly, to enhance the effectiveness of their
use; but, taken in the aggregate, it serves only to widen the
discrepancy between business capital and industrial equipment. So
long as times are brisk this discrepancy ordinarily goes on
widening through a progressive extension of credit. Funds
obtained on credit are applied to extend the business; competing
business men bid up the material items of industrial equipment by
the use of funds so obtained; the value of the material items
employed in industry advances; the aggregate of values employed
in a given undertaking increases, with or without a physical
increase of the industrial material engaged; but since an advance
of credit rests on the collateral as expressed in terms of value,
an enhanced value of the property affords a basis for a further
extension of credit, and so on.(13*)

Now, the base line of business transactions is the money
value (market or exchange value, price) of the items involved,
not their material efficiency. The value of the money unit is by
conventional usage held to be invariable, and the lenders
perforce proceed on this assumption, so long as they proceed at
all.(14*) Consequently, any increase of the aggregate money
values involved in the current industrial business enterprises
will afford a basis for an extension of loans, indistinguishable
from any other block of capitalized values, even if the increase
of capitalized values is due to credit advances previously made
on the full cash value of the property hypothecated, The
extension of loans on collateral, such as stock and similar
values involved in industrial business, has therefore in the
nature of things a cumulative character. This cumulative
extension of credit through the enhancement of prices goes on, if
otherwise undisturbed, so long as no adverse price phenomenon
obtrudes itself with sufficient force to convict this cumulative
enhancement of capitalized values of imbecility. The extension of
credit proceeds on the putative stability of the money value of
the capitalized industrial material, whose money value is
cumulatively augmented by this extension itself. But the money
value of the collateral is at the same time the capitalized value
of the property, computed on the basis of its presumptive
earning-capacity. These two methods of rating the value of
collateral must approximately coincide, if the capitalization is
to afford a stable basis for credit; and when an obvious
discrepancy arises between the outcome given by the two ratings,
then a rerating will be had in which the rating on the basis of
earning-capacity must be accepted as definitive, since earnings
are the ground fact about which all business transactions turn
and to which all business enterprise converges. A manifest
discrepancy presently arises in this way between the aggregate
nominal capital (capital plus loans) engaged in business, on the
one hand, and the actual rate of earning-capacity of this
business capital, on the other hand; and when this discrepancy
has become patent a period of liquidation begins.

To give a readier view of the part played by loan credit in
this discrepancy between the business capital and the
earning-capacity of industrial concerns, it will be in place to
indicate more summarily what are the factors at play.

The earnings of the business community, taken as a whole, are
derived from the marketable output of goods and services turned
out by the industrial process - disregarding such earnings as
accrue to one concern merely at the cost of another. The
effective industrial capital, from the use of which this output,
and therefore these earnings, arise, is the aggregate of
capitalized material items actually engaged in industry. The
business capital, on the other hand, is made up of this
capitalized industrial material taken as a fund of values, plus
good-will, plus whatever funds are obtained on credit by using
this capitalized industrial material as collateral, plus funds
obtained on other, non-industrial, property used as collateral.
Through the competitive use of funds obtained on credit, as
spoken of above, the nominal value of the capitalized industrial
material is cumulatively augmented so as to make it approximately
equal to its original capitalization plus whatever funds are
obtained on credit of all kinds. On this basis of an expanded
collateral a further extension of credit takes place, and the
funds so obtained are incorporated in the business capital and
turned to the like competitive use, and so on.(15*) Capital and
earnings are counted in terms of the money unit. Counted in these
terms, the earnings (industrial output) are also increased by the
process of iflation though credit, since the competitive Use of
funds spoken of acts to bid up prices of whatever products are
used in industry, and of whatever speculative property is
presumed to have some eventual industrial use. But the nominal
magnitude (value) of the earnings is not increased in as large a
ratio as that of the business capital; since the demand whereby
the values of the output are regulated is not altogether a
business demand (for productive goods), but is in great part, and
indeed in the last resort mainly, reducible to a consumptive
demand for finished goods.(16*)

Looking at credit extension and its use for purposes of
capital as a whole, the outcome which presents itself most
strikingly at a period of liquidation is the redistribution of
the ownership of industrial property incident to the liquidation.
The funds obtained on credit are in great measure invested
competitively in the same aggregate of material items that is
already employed in industry apart from the use of loan credit,
with the result that the same range of items of wealth are rated
at a larger number of money units. In these items of wealth -
which, apart from the use of credit, are owned by their nominal
owners - the creditors, by virtue of the credit extension, come
to own an undivided interest proportioned to the advances which
they have made. The aggregate of these items of property comes
hereby to be potentially owned by the creditors in approximately
the proportion which the loans bear to the collatcral plus the
loans. The outcome of credit extension, in this respect, is a
situation in which the creditors have become potential owners of
such a fraction of the industrial equipment as would be
represented by the formula: (17*)

loans/capitalization (=collateral + loans)

In a period of liquidation this potential ownership on the part
of the creditors takes effect to the extent to which the
liquidation is carried through.(18*)

The precise measure and proportion in which the industrial
property of the business community passes into the hands of the
creditors in a period of liquidation can, of course, not be
specified; it depends on the degree of shrinkage in values, as
well as on the degree of thoroughness with which the liquidation
is carried out, and perhaps on other still less ascertainable
causes, among which is the degree of closeness of organization of
the business community. It is, however, through the shrinkage of
market values of the output and the industrial plant that the
transfer of ownership to the creditor class takes place. In case
no shrinkage of values took place, no such general transfer of
ownership to the creditors as a class would become evident.

In point of fact, the shrinkage commonly supervenes, in the
course of modern business, when a general liquidation comes;
although it is conceivable that the period of acute liquidation
and its attendant shrinkage of values need not supervene. Such
would probably be the case in the absence of competitive
investment in industrial material on a large scale. Secondary
effects, such as perturbations of the rate of interest,
insolvency, forced sales, and the like, need scarcely be taken up
here, although it may be well to keep in mind that these
secondary effects are commonly very considerable and farreaching,
and that they may in specific instances very materially affect
the outcome.

The theoretical result of this summary sketch of loan credit
so far seems to be: (a) an extension of loan credit beyond that
involved in the transference of productive goods from their
owners to more competent users is unavoidable under the regime of
competitive business - credit expansion is normally in some
degree "abnormal" or "excessive"; (b) such a use of credit does
not add to the aggregate of industrially productive equipment nor
increase its material output of product, and therefore it does
not add materially to the aggregate gross earnings obtained by
the body of business men engaged in industry, as counted in
material terms of wealth or of permanent values;(19*) (c) it
diminishes the aggregate net profits obtained by the business men
engaged in industry, as counted in such terms, in that it
requires them to pay interest, to creditors outside the
industrial process proper, on funds which, taken as an aggregate,
represent no productive goods and have no aggregate productive
effect; (d) there results an overrating of the aggregate capital
engaged in industry, compared with the value of the industrial
equipment at the starting-point, by approximately the amount of
the aggregate deposits and loans on collateral; (e) the
overrating swells the business capital, thereby raises the
valuation of collateral, and gives rise to a further extension of
credit, with further results of a like nature; (f) commonly
beginning at some point where the extension of credit is
exceptionally large in proportion to the material substratum of
productive goods, or where the discrepancy between nominal
capital and earning-capacity is exceptionally wide, the
overrating is presently recognized by the creditor and a
settlement ensues; (g) on the consequent withdrawal of credit a
forced rerating of the aggregate capital follows, bringing the
nominal aggregate into approximate accord with the facts of
earning-capacity; (h) the shrinkage which takes place in reducing
the aggregate rating of business capital from the basis of
capital goods plus loans to the basis of capital goods alone,
takes place at the expense of debtors and nominal owners of
industrial equipment, in so far as they are solvent; (i) in the
period of liquidation the gain represented by the credit
inflation goes to the creditors and claimants of funds outside
the industrial process proper, except that so much as is
cancelled in bad debts is written off; (j) apart from secondary
effects, such as heightened efficiency of industry due to
inflated values, changes of the rate of interest, insolvency,
etc., the main final outcome is a redistribution of the ownership
of property whereby the creditor class, including holders and
claimants of funds, is benefited.

Since the modern industrial situation began to take form,
there have been two principal forms of credit transactions
current in the usage of the business community for the purpose of
investment: the old-fashioned loan, the usage of which has come
down from an earlier, day. and the stock share, whereby funds are
invested in a joint stock company or corporation. The latter is a
credit instrument, so far as touches the management of the
property represented, in that (in earlier usage at least) it
effects a transfer of a given body of property from the hands of
an owner who resigns discretion in its control to a board of
directors who assume the management of it. In addition to these
two methods of credit relation there has, during the late-modern
industrial period, come into extensive use a third class of
expedients, viz. debentures of one form and another - bonds of
various tenor, preferred stock, preference shares, etc., ranging,
in point of technical character and degree of liability, from
something approaching the nature of a bill of sale to something
not readily distinguishable in effect from a personal note. The
typical (latest and most highly specialized) instrument of this
class is the preferred stock. This is in form a deed of ownership
and in effect an evidence of debt. It is typical of a somewhat
comprehensive class of securities in use in the business
community, in the respect that it sets aside the distinction
between capital and credit. In this respect, indeed, preferred
stock, more adequately perhaps than any other instrument,
reflects the nature of the "capital concept" current among the
up-to-date business men who are engaged in the larger industrial
affairs.

The part which debenture credit, nominal and virtual, plays
in the financing of modern industrial corporations is very
considerable, and the proportion which it bears in the
capitalization of these corporations apparently grows larger as
time passes and shrewder methods of business gain ground. In the
field of the "industrials" proper, debenture credit has not until
lately been employed with full effect. It seems to be from the
corporation finance of American railway companies that business
men have learned the full use of an exhaustive debenture credit
as an expedient for expanding business capital. It is not an
expedient newly discovered, but its free use, even in railway
finance, is relatively late. Wherever it prevails in an
unmitigated form, as with some railway companies, and latterly in
many other industrial enterprises, it throws the capitalization
of the business concerns affected by it into a peculiar,
characteristically modern, position in relation to credit. When
carried out thoroughly it places virtually the entire capital,
comprising the whole of the material equipment, on a credit
basis. Stock being issued by the use of such funds as will pay
for printing the instruments, a road will be built or an
industrial plant established by the use of funds drawn from the
sale of bonds; preferred stock or similar debentures will then be
issued, commonly of various denominations, to the full amount
that the property will bear, and not infrequently somewhat in
excess of what the property will bear. When the latter case
occurs, the market quotations of the securities will, of course,
roughly adjust the current effective capitalization to the run of
the facts, whatever the nominal capitalization may be. The common
stock in such a case represents "goodwill," and in the later
development it usually represents nothing but "good-will."(20*)
The material equipment is covered by credit instruments
debentures. Not infrequently the debentures cover appreciably
more than the value of the material equipment, together with such
property as useful patent rights or trade secrets; in such a case
the good-will is also, to some extent, covered by debentures, and
so serves as virtual collateral for a credit extension which is
incorporated in the business capital of the company. In the ideal
case, where a corporation is financed with due perspicacity,
there will be but an inappreciable proportion of the market value
of the company's good-will left uncovered by debentures. In the
case of a railway company, for instance, no more should be left
uncovered by debentures than the value of the "franchise," and
probably in most cases not that much actually is uncovered.

Whether capitalized good-will (including "franchise" if
necessary) is to be rated as a credit extension is a nice
question that can apparently be decided only on a legal
technicality. In any case so much seems clear - that good-will is
the nucleus of capitalization in modern corporation finance. In a
well financed, flourishing corporation, good-will, indeed,
constitutes the total remaining assets after liabilities have
been met, but the total remaining assets may not nearly equal the
total market value of the company's good-will; that is to say,
the material equipment (plant, etc.) of a shrewdly managed
concern is hypothecated at least once, commonly more than once,
and its immaterial properties (good-will), together with the
evidences of its indebtedness, may also to some extent be drawn
into the hypothecation.(21*)

What has just been said of the part borne by good-will and
debentures in the capitalization of corporations should be taken
in connection with what was said above (pp. 100-104) as to the
nature of the securities offered as collateral in procuring a
credit extension. The greatcr part of the securities used as
collateral, and so "coined into means of payment," are evidences
of debt, at the first remove or farther from their physical
basis, instruments of credit recording a previous credit
extension.

In the earlier period of growth of this debenture
financiering in industry, as, e.g., in the railroad financiering
of the third quarter of the nineteenth century, the process of
expansion by means of debenture credit, in any given case, was
worked out gradually, over a more or less extended period of
time. But as the possibilities of this expedient have grown
familiar to the business community, the time consumed in
perfecting the structure of debentures in each case has been
reduced; until it is now not unusual to perfect the whole
organizztion, with its load of debentures, at the inception of a
corporate enterprise. In such a case, when a corporation starts
with a fully organized capital and debt, the owners of the
concern are also its creditors; they are, at the start, the
holders of both common and preferred stock, and probably also of
the bonds of the company - so adding another increment of
confusion to the relation between modern capital and credit, as
seen from the old-fashioned position as to what capitalization
and its basis should be.

This syncopated process of expanding capital by the help of
credit financiering, however, is seen at its best in the
latter-day reorganizations and coalitions of industrial
corporations; and as this class of transactions also illustrate
another interesting and characteristically modern feature of
credit financiering, the whole matter may best be set out in the
way of a sketch of what takes place in a case of coalition of
industrial corporations on a large scale such as recent
industrial history has made familiar.

The avowed end of these latter-day business coalitions is
economy of production and sale and an amicable regulation of
intercorporate relations. So far as bears on the functioning of
credit in the attendant business transactions, the presence or
absence of these purposes, of course, does not affect the course
of events or the outcome. These avowed incentives do not touch
the credit operations involved. On the other hand, the need of
large credit in consummating the deal, as well as the presumptive
gains to be drawn from the credit relations involved, offer
inducements of their own to men who are in a position to effect
such a coalition. Inducements of this kind seem to have been of
notable effect in bringing on some of the recent operations of
this class.

Credit operations come into these transactions mainly at two
points: in the "financing" of the deal, and in the augmentation
of debentures; and at both of these points there is a chance of
gain on the one hand to the promoter (organizer) and the credit
house which finances the operation, and on the other hand to the
stockholders. The gain which accrues to the two former is the
more unequivocal, and this seems in some cases to be the dominant
incentive to effect the reorganization. The whole operation of
reorganization may, therefore, best be taken up from the point of
view of the promoter, who is the prime mover in the matter.

A reorganization of industrial concerns on a large scale,
such as are not uncommon at the present time, involves a campaign
of business strategy, engaging, it is said, abilities and
responsibilities of a very high order. Such a campaign of
business strategy, as carried out by the modern captains of
industry, runs, in the main, on credit relations, in the way of
financial backing, options, purchases, leases, and the issuance
and transfer of stock and debentures. In order to carry through
these large "deals," in the first place, a very substantial basis
of credit is required, either in the hands of the promoter
(organizer) himself or in the hands of a credit house which
"finances" the organization for him.

The strategic use of credit here involved is, in effect, very
different from the old-time use of loan credit in investments. In
transactions of this class the time element, the credit period,
is an inconspicuous factor at the most; it plays a very
subordinate and uncertain part. The volume of credit at the
disposal of a given strategist is altogether the decisive point,
as contrasted with the lapse of time over which the incident
credit extension may run. The usefulness of the credit extension
is not measured in terms of time, nor are the gains which accrue
to the creditor in the case proportioned to the length of time
involved.

This follows from the peculiar nature of the work which these
great captains of industry have in hand, and more remotely,
therefore, from the peculiar character of the earnings which
induce them to undertake the work. Their work, though it is of
the gravest consequence to industry, is not industrial business,
in that it is not occupied with anything like the conduct of a
continuous industrial process. Nor is it of the same class as
commercial business, or even banking business, in that there is
no investment in a continued sequence of transactions. It differs
also from stock and produce speculation, as that is currently
conceived,(22*) in that it does not depend on the lapse of time
to bring a change of circumstances; although it has many points
of similarity with stock speculation. In its details this work
resembles commercial business, in that it has to do with
bargaining; but so does all business, and this peculiar work of
the trust promoter differs from mercantile business in the
absence of continuity. Perhaps its nearest business analogue is
the work of the real estate agent.

The volume of credit involved is commonly very great; whereas
the credit period, the lapse of time, is a negligible factor.
Indeed, if an appreciable credit period intervenes, that is a
fortuitous circumstance. The time element in these credit
operations is in abeyance, or at the best, it is an indeterminate
magnitude. Hence the formula shown above (p. 95, n. 3) is
practically not applicable to business of this class. So far as
bears upon the credit operations involved in these transactions
of the large finance, the question about which interest turns is
almost exclusively the volume of the turnover; its velocity is a
negligible quantity. Such strategic use of credit is not confined
to the business of making or marring industrial coalitions. It is
habitually to be met with in connection with stock (and produce)
speculation, and ramifications of the like use of credit run
through the dealings of the business community at large in many
directions; but it rarely attains the magnitude in the service of
stock speculation which it reaches in the campaign incident to a
trust-making deal. The form of credit extension employed in these
transactions with indeterminate time also varies. The older and
more familiar form is that of the call loan, together with the
stock exchange transactions for which call loans are largely
used. Here the time element is present, especially in form; but
the credit period is somewhat indeterminate, as is also the gain
that accrues to the creditor from the transaction; although the
creditor's gain here continues to be counted at a (variable) rate
per cent. per time-unit. The strategic use of credit in the
affairs of the large business finance has much in common with the
call loan. Indeed, the call loan in set form is often resorted to
as a valuable auxiliary recourse, although the larger
arrangements for financing such a campaign of business strategy
are not usually put in the form of a call loan. The arrangement
between the promoter and the financial agent is commonly based on
a less specific stipulation as to collateral, and the payment for
credit obtained takes even less, if any, account of the length of
the credit period. In financing a campaign of coalition the
credit house that acts as financial agent assumes, in effect, an
even less determinate credit responsibility. Here, too, the gains
accruing to the creditor are no longer, even nominally, counted
per cent. per time-unit, but rather in the form of a bonus based
mainly on the volume of the turnover, with some variable degree
of regard to other circumstances.

Answering to the essentially timeless character of the gains
accruing to the financial agent, the earnings of the promoter
engaged in transactions of this class are also not of the nature
of profits per cent. per time-unit, but rather a bonus which
commonly falls immediately into the shape of a share in the
capitalization of the newly organized concern. Much of the
increment of capital, or capitalization, that goes to the
promoter is scarcely distinguishable from an increase of the
liabilities of the new corporation (e.g. preferred stock); and
the remainder (e.g. common stock) has also some of the
characteristics of a credit instrument. It is worth noting that
the cost of reorganization, including the bonus of the promoter
and the financial agent, is, in the common run of cases, added to
the capitalization; that is to say, as near as this class of
transactions may be spoken of in terms borrowed from the
old-fashioned business terminology, what answers to the
"interest" due the creditor on the credit extension involved is
incorporated in the "capital" of the debtor, without
circumlocution or faltering.(23*)

The line between credit and capital, or between debt and
property, in the values handled throughout these strategic
operations of coalition, remains somewhat uncertain. Indeed, the
old-fashioned concepts of "debt" and "property," or "liabilities"
and "assets," are not fairly applicable to the facts of the case
- except, of course, in the way of a technical legal distinction.
The old-fashioned law and legal presumptions and the
new-fashioned facts and usages are parting company, at this point
as well as at some others in the affairs of modern business.

When such a large transaction in the reorganization of
industrial concerns has been completed, the values left in the
hands of the former owners of the concerns merged in the new
coalition are only to a fractional and uncertain extent of the
nature of material goods. They are in large part debentures, and
much of the remainder is of a doubtful character. A large
proportion of the nominal collective capital resulting in such
cases is made up of the capitalized good-will of the concerns
merged.(24*) This good-will is chiefly a capitalization of the
differential advantages possessed by the several concerns as
competitors in business, and is for the most part of no use for
other than competitive business ends. It has for the most part no
aggregate industrial effect. The differential advantages
possessed by business concerns as competitors disappear when the
competitors are merged, in the degree in which they cease to
compete with rival bidders for the same range of business. To
this aggregate defunct good-will of the consolidated concerns
(which in the nature of things can make only an imaginary
aggregate) is added something in the way of an increment of
good-will belonging to the new corporation as such;(25*) and the
whole is then represented, approximately, by the common stock
issued. The nominal capital of the concerns merged (in good part
based on capitalized goodwill) is aggregated, after an
appraisement which commonly equalizes the proportion of each by
increasing the nominal shares of all. This aggregate is covered
with common and preferred stock, chiefly preferred, which is a
class of debentures issued under the form of capital. The stock,
common and preferred, goes to the owners of the concerns merged,
and to the promoter and the financial agent, as indicated above.
In case bonds are issued, these likewise go to the former owners,
in so far as they do not replace outstanding liabilities of the
concerns merged.

"Capital" in the enlightened modern business usage means
"capitalized presumptive earning-capacity," and in this
capitalization is comprised the usufruct of whatever credit
extension the given business concern's industrial equipment and
good-will will support.(26*) By consequence the effectual
capitalization (shown by the market quotations) as contrasted
with the nominal capital (shown by the par value of the stock of
all descriptions) fluctuates with the fluctuations of the
prevalent presumption as to the solvency and earning-capacity of
the concern and the good faith of its governing board.

When the modern captain of industry reorganizes and
consolidates a given range of industrial business concerns,
therefore, and gives them a collective form and name as an
up-to-date corporation, the completed operation presents, in
syncopated form and within a negligible lapse of time, all that
intricate process of cumulative augmentation of business capital
through the use of credit which otherwise may come gradually in
the course of business competition. At the same time it involves
a redistribution of the ownership of the property engaged in
industry, such as otherwise occurs at a period of liquidation.
The result is, of course, not the same at all points, but the
equivalence between the two methods of expanding business capital
and distributing the gains is close in some respects. The
resemblances and the differences between the two processes, so
far as relates to credit, are worth noticing. The trust-maker is
in some respects a surrogate for a commercial crisis.

When credit extension is used competitively in the
old-fashioned way for increasing the business of competing
concerns, as spoken of above (pp. 94-100, 109-114), the expansion
of business capital through credit operations occupies a period
of some duration, commonly running over an interval recognized as
a period of speculative advance or "rising prosperity." The
expansion of capitalized values then takes place more or less
gradually through a competitive enhancement of the prices of
industrial equipment and the like. The creditors then commonly
come in for their resulting share in the industrial equipment
only at the period of liquidation, with its attendant shrinkage
of values. In the timeless credit transactions involved in the
modern reorganizations of industrial business, on the other hand,
the creditors' claim takes effect without an appreciable lapse of
time, a liquidation, or a shrinkage of values.

The whole process of credit extension, augmentation of
business capital, and distribution of proceeds is reduced to a
very simple form. The credit extension is effected in two main
forms: (a) the "financing" undertaken by the credit house in
conjunction with the promoter, and (b) the issuance of
debentures. The bonus of the financing house and promoter, as
well as the debentures, are all included in the recapitalization,
together with an increment of good-will and any other incidental
items of expense or presumptive gain. The resulting collective
capitalization (assets and liabilities) is then distributed to
the several parties concerned in the transaction. The outcome, so
far as touches the present argument, being that when the
operation is completed the ownership of the recapitalized
industrial equipment, with whatever other property is involved,
appears distributed between the former owners, the promotcr, and
the credit house which financed the operation. But, by virtue of
the debentures distributed, the former owners, together with the
other parties named, appear in the role of creditors of the new
corporation as well as owners of it; they commonly come out of
the transaction with large holdings of preferred stock or similar
debentures at the same time that they hold the coommon stock. The
preferred stock, of course, is presently disposed of by the
large holders to outside parties. The material equipment is then
practically the same as it was before; the business capital has
been augmented to comprise such proportion of the goodwill of the
several concerns incorporated as had not previously been
capitalized and hypothecated, together with the good-will imputed
to the new corporation and such debentures as these items of
wealth will float.

The effective capitalization resulting is, of course,
indicated by the market quotations of the securities issued
rather than by their face value. The value of the corporation's
business capital so indicated need suffer no permanent shrinkage;
it will suffer none if the monopoly advantage (good-will) of the
new corporation is sufficient to keep its earning-capacity up to
the rate on which the capitalization is based.

It appears, then, that in the affairs of latterday business,
as shown by modern corporation finance, capital and credit
extension are not always distinguishable in fact, nor does there
appear to be a decisive business reason why they should be
distinguished. "Capital" means "capitalized putative
earning-capacity," expressed in terms of value, and this
capitalization comprises the use of all feasible credit
extension. The business capital of a modern corporation is a
magnitude that fluctuates from day to day; and in the quotations
of its debentures the magnitude of its credit extension also
fluctuates from day to day with the course of the market. The
precise pecuniary magn itude of the business community's invested
wealth, as well as the aggregate amount of the community's
indebtedness, depends from hour to hour on the quotations of the
stock exchange; and it rarely happens that it remains nearly the
same in the aggregate from one week's end to the next. Both
capital and credit, therefore, vary from hour to hour. and,
within narrow limits, from place to place. The magnitude and
fluctuations of business capital, - "capital" in the sense in
which that term is used in business affairs, - of course, stand
in no hard and fast relation to the material magnitude of the
industrial equipment; nor do variations in the magnitude of the
business capital reflect variations in the magnitude or the
efficiency of the industrial equipment in any but the loosest and
most indecisive manner. So also, and for the same reason, the
magnitude and the variations of the aggregate credit afloat at a
given time bear, at the most, but a remote, indirect, and shifty
relation to the aggregate of material wealth and the material
changes to which this wealth is subject. All this applies with
peculiar cogency wherever and in so far as industry and business
are carried on hy modern expedients and in due contact with the
market.

NOTES:

1. This, of course, has nothing to say to Bohm-Bawerk's theory of
the enhancement of production through lengthening the processes
of industry. His theory of the "roundabout method" applies to the
technical, material efficiency of the mechanical process; whereas
the point in question here is the interval occupied in the
turning over of a given business capital. Bohm-Bawerk's position
may be questionable, however, on other grounds. 

2. Cf., e.g., Werner Sombart, "Der Stil des modernen
Wirthschaftslebens." Achiv fur soz. Gestzg. u. Statistik, vol.
XVII, pp. 1-20, especially pp. 4-15. Reprinted as ch. IV, vol. II
of Der moderne Kapitalismus (Leipzig, 1902).

3. Cf., e.g., Marshall, Principles of Economics (3d ed.), bk VI,
ch. VII, secs. 3 and 4.

4. Cf. Laughlin, Principles of Money, p. 86.

5. The turnover will count for more in gross earnings at current
rates if instead of his own capital alone the business man also
engages whatever funds he can borrow by using his capital as
collateral. The turnover counted on capital (value of the
industrial equipment) plus credit, at current rates, will be
greater than that counted on the capital aaone used without
credit extension. The turnover may be expressed as the product of
the mass of values employed multiplied by the velocity. Hence, if
credit be taken as an indeterminate fraction (capital/n) of the
capital used as collateral, we may say that

Turnover = (1/time)(capital + capital/n), i.e.

T = (1/t)(c + c/n) = (c + c/n)/t; t = (c + c/n)/T

The algebraic statement serves to bring out the equivalence
between an acceleration of the rate of turnover and an increase
of the volume of business capital. Cf. Jevons, Theory of
Political Economy, pp. 249-258.

Sombart is mistaken in saying (Kapitalismus, vol. II. ch. VI,
p. 74) that the use of credit lengthens the time of turnover of
capital. Credit shortens the time relatively to the magnitude of
the turnover; i.e. a given initial capital by the help of credit
turns over a larger pecuniary magnitude in a given time: (c +
c/n)/t > c/t.

6. Marshall, as above.

7. Cf. Laughlin, Principles of Money, ch. IV.

8. Property convertible into cash at will.

9. The legally obligatory reserve for the National Banks, for
instance, is 25 per cent of combined note circulation and
deposits in central reserve banks, 15 per cent in others. --
Revised Statutes, 5191.

10. This takes accountof advance made by other lenders than the
regular banking houses who exclude mortgages on real estate from
their collateral; such, e.g., as the long time advances
(investments in securities) made by saving banks, insurance
companies, minor private and mortgage banks, private lenders,
etc.

11. This truism is frequently overlooked in theoretical
discussions; hence, as the present argument requires its
recognition, it is here stated in this explicit way.

12. The cash loans made by depositors to savings banks in the
form of deposits.

13. Cf. Twelfth Census of the United States, vol. VII, p. c.

14. Few, perhaps, would in set terms maintain an argument that
the value of money does not vary, but still fewer would, in a
credit transaction, proceed on a supposition at variance with
that position. As the economists are accustomed to say, money is
the standard of deferred payments. It is also, in the
unreflecting apprehension of those who have practically to deal
with wealth phenomena, felt to be the standard and inflexible
measure of wealth. The fact that this convertional usage is
embodied in law acts acts greatly to fortify the naive acceptance
of money and price as the definitive terms of wealth. See pp.
82-86 above.

15. Cf. Knies, Geld and Credit, vol. II, ch. VI, sec. C,
especially pp. 303 et seq.

16. The enhancement of the market value of the output does not,
in fact, keep pace with the inflation of business capital during
a period of speculative advance. In order that it should do so,
and afford nominal earnings proportionate to the inflated
capital, it would be necessary that incomes should increase
proportionately to the inflation of capital; but, even if this
happened, the expenses of production would thereby be so
increased (through the advance of wages and the like) as to
offset the entire of values for all consumptive goods and leave
only the advance in the values of productive goods as a net
margin from which to draw an increase of earnings. The
discrepancy under discussion, however, is not due entirely to the
presence of credit, and a fully detailed analysis of the causes
out of which it arises can, therefore, not properly be presented
in this place.

17. So long as the rating of the capitalized property remains
undisturbed, the formual which expresses the creditors' claim
maintain the form given above. It then signifies nothing more
than that the creditors hold a claim on such a proportion of the
aggregate capitalized property involved as their advances bear to
the aggreage capitalization. But so soon as a rerating of the
capitalized property enters the problem the formula becomes

loans/(capitalization + delta capitalization)

or  loans/(capitalization - delta capitalization),

according as the rerating of capitalization is in the direction
of enhancement or depreciation: 1/(cap + delta cap) or 1/(cap -
delta cap). During brisk times, when capitalization advances,the
claim represented by a given loan covers a decreasing proportion
of the aggregate capitalized property involved 1/(cap + delta
cap); the denominator increases and teh quotient consequently
decreases. Whereas, in a period of liquidation the ratio of the
creditors' claim to the aggregate capitalization increases by
force of the lowered rating of the capitalized property 1/(cap -
deltal cap).

18. All those who, at a period of liquidation, are holders of
fluent funds or of claims to fixed sums of money are, for the
present purpose, in the position of creditors.

19. This disregards the indirect effects of a speculative advance
in the way of heightened intensity of application and fuller
employment of the industrial plant.

20. See chapter VI.

21. The question of "stock watering" "overcapitalization" and the
like is scarcely pertinent in the case of a large industrial
corporation financed as the modern situation demands. Under
modern circumstances the common stock can scarcely fail to be all
"water", unless in a small concern or under incompetent
management. Nothing but "water" - under the name of good-will -
belongs in the common stock; whereas the preferred stock, which
represents material equipment, is a debenture.
"Overcapitalization," on the other hand, if it means anything
under modern business conditions, must mean overcapitalization as
compared with earning-capacity, for there is nothing else
pertinent to compare it with; and earning-capacity fluctuates,
while the basis (interest rates) on which the earning-capacity is
to be capitalized also fluctuates independently.

In effect, the adjustment of capitalization to
earning-capacity is taken care of by the market quotations of
stock and other securities; and no other method of adjustment is
of any avail, because capitalization is a question of value, and
market quotations are the last resort in questions of value. The
value of any stock listed on the exchange, or otherwise subject
to purchase and sale, fluctuates from time to time; which comes
to the same thing as saying that the effectual capitalization of
the concern, represented by the securities quoted, fluctuates
from time to time. It fluctuates more or less, sometimes very
slowly, but always at least so much as to compensate the
long-period fluctuations of discount rates in the money market;
which means that the purchase price of a given fractional
interest in the corporation as a going concern fluctuates so as
to equate it with the capitalized value of its putative
earning-capacity, computed at current rates of discount and
allowing for risks. Cf. Report of the Industrial Commission, vol.
I. p. 587 (Testimony of Rogers); vol. XIII. pp. 106-107
(Testimony of E.R. Chapman). See also Chapter VI below.

22. See, e.g. Emery, Speculation on the Stock and Produce
Exchanges of the United States, ch. IV; Hadley, Economics, ch.
IV.

23. Report of the Industrial Commission, vol. I, (Testimony of
W.H. Moore) pp. 960-963, (W.E. Reis) p. 949, (Gates) p. 1032;
vol. IX. (T.L. Greene) p. 491; vol. XIII, p. viii, with
corresponding testimony. See also Chapter VI below.

24. Report of the Industrial Commission, vol. I (Testimony of
Dodd) pp. 1054-1055, 1057, 1058-1059, (Gates) pp. 1021-1022; vol.
XIII, p. ix, with testimony.

25. Report of the Industrial Commission, vol. I (Testimony of Dos
Passos) p. 1179; vol. XIII (C.R. Flint) p. 48. Testimony to the
same effect recurs elsewhere in the Report. See p. 125, n. 1
above.

26. See Chapter VI below.