Joined Nov 11, 2007
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The Fed, Mal Investment, and the Unproductive Use of Credit

“Great fortunes are built on the proper use of credit. Improper use of credit leads to mal-investment and wealth destruction.

We cannot understand our fundamental financial problems if we do not understand the proper use of credit. Credit has a key role in capitalism; credit-starved economies are underdeveloped economies, as economist Hernando De Soto explained in his masterwork, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.

In the chronically underdeveloped economies De Soto describes, households have assets–land, dwellings, small businesses–but since the assets do not have legally recognized status as “property” (because the system for recognizing and registering property is both cumbersome and corrupt), they cannot act as collateral for borrowed capital, i.e. loans.

As a result, the majority of the assets are “dead capital,” difficult to sell, pass on to future generations or use as collateral.

Great fortunes are built on the proper use of credit. The borrower needs capital to expand his/her enterprise, and the lender needs a fast-growing enterprise with collateral and an income stream to support a low-risk, high-yield loan.

We can profitably look to Colonial America as an example of a credit-starved economy. In the wake of the Revolutionary war and the ratification of the Constitution (1789), the U.S. financial system was a mess: debts left by the war burdened the new government, which historian Thomas McCaw noted “started on a shoestring and almost immediately went bankrupt.”

Differing views on the role of the central government, central bank and credit splintered the political elite, with Hamilton squaring off against Madison and Jefferson (though Madison’s views were by no means identical to Jefferson’s).

Meanwhile, in the real economy, ordinary farmers and entrepreneurs were desperate for long-term credit to fuel their rapidly growing enterprises. Though states were banned by the Constitution from issuing their own currency, states got around this prohibition by granting bank charters. The banks promptly issued the credit that an entrepreneurial economy needed.

The political elite, regardless of their differences, were appalled by this explosion of privately issued and essentially unregulated credit, but this access to credit–turning “dead capital” into collateral–fueled the astonishing growth of the U.S. economy in the 1790s and early 1800s.

The American economy in this phase was anything but orderly or well-regulated. Wild and risky better describe the financial and commercial chaos of the era, but this untamed capitalism led to more successes than failures, and the bankrupt enterprises and busted banks were absorbed by the fast growth of the real economy.

This chaotic explosion of credit and entrepreneurial drive was the opposite of central planning. Risk was everywhere; security in today’s meaning did not exist….”

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