Credit is Economically Scarce, a Good Thing

Credit is here meant to be commercial credit, used in part for business expansion and the funding of new enterprises.

Economically scarce here means 'not supplied in excess of all possible demand.'

While credit itself is a positive thing, adding to the timely supply of goods and services available for consumption in the economy, that does not imply that more credit is a benefit, nor that less is a detriment, to the economy. As is often the case in economics, marginal analysis is required to get a true picture.

For simplicity and concreteness, assume that a total of $100 billion of commercial bank credit is available. This total supports a certain level of business expansion and new businesses. (Ignore the fact that alternate financing possibilities exist, such as the use of equity.) In turn, this eventually results in an increased stream of both new and existing consumer products.

Conceptually break up the $100B of credit into 5 quintiles, the first being 0 to $20B, the second being $20B to $40B, etc., with the fifth being $80B to $100B.

If only the first quintile, representing up to $20B of credit, were available, what would be the difference to the economy?

First, we would find that the stream of consumer products, both new and existing, would be diminished, relative to having $100B of credit available. Secondly, we would find that the interest rates for commercial loans would be higher, as the commercial banks try to maximize their profits on the limited amount of loanable funds available to them.

What can we say about the actual consumer products that result from the first quintile loans?

First, the proposed use of the first quintile loans will tend to result in investments that produce higher returns . The higher interest rates will tend to weed out the more marginal investments with lower expected returns, and the remaining investments will tend to produce consumer products that are expected to be of more subjective value to consumers, who should in turn be more willing to pay more for value received.

Secondly, the banks will pick and choose the loan recipients in terms of risk, at the already elevated interest rates. It is likely that very few of these loans will fail to be paid back.

If we now turn to the fifth quintile, what do we see?

We see lower interest rates and loan recipients with much higher risk of default. We see investment in products of relatively low profitability and much lower expectations of consumer subjective value.

In addition, the fifth quintile loans tend to injure the recipients of the lower quintile loans, as well as all the businesses that aren't borrowing money at all. The marginal companies that only get loan funding if more than $80B in commercial loan funds are available tend to fail at high relative rates and completely waste all the resources that they manage to acquire before they fail. In doing so, they bid up all the factor prices faced by all of the surviving companies, whether loan recipients or not, reducing their profitability.

But even if a marginal company survives, it still is a source of injury to all other companies and the economy as a whole. After bidding up factor prices, it now competes for consumer dollars, even if it doesn't directly compete in a given market segment. All other companies see reduced profits and reduced demand for output. Consumers consume less of the products of all the other companies.

Competition is generally a good thing in itself between companies in as they try to satisfy the demands of consumers, but in this case we have a competition between the specific companies that would not exist in the absence of the fifth loan quintile and all the rest. The fact is that the products that are produced by the fifth quintile companies are also likely to be marginal products themselves, expected to be of less value to consumers than the products of all the other companies. While consumers can make their own choices from the products available, the existence of the fifth quintile companies tends to suppress the quantities of consumer products made available for sale by all of the other companies, as they maximize their profits by adjusting their pricing and output levels, likely resulting in lower consumer satisfaction consumer by consumer than if only $80B in commercial loans were available. This is only a hypothetical comparison, not one that is available to consumers in the real world.

Of course, we have no way of being sure that the fifth quintile $20B of loans is the first one that is counter-productive. It could be less, or it could be more. However, it seems highly likely that some level of commercial loans exists for which an increase is counter-productive. To believe otherwise is somewhat analogous to always being ready to co-sign the bank loans of your brother-in-law.

It seems highly likely that an almost entirely parallel argument can be made for the level of funds available for equity investment, but I won't try to make that here.

The scarcity of loans has a positive benefit to the economy, as it serves as a gatekeeper , turning away marginal potential debtors.

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"It is likely that very few

"It is likely that very few of these loans [from the first quintile] will fail to be paid back."

I am wondering how your assumptions regarding the behavior of entrepreneurs differ from the assumptions made in "mainstream" models of credit rationing. In those models (like Stiglitz & Weiss, Williamson, etc) the higher interest rate weeds out those projects that entrepreneurs believe have a lower expected rate of return, just as you suggest. However, those projects that entrepreneurs feel would still be profitable at the higher interest rate, are also those that are assumed to be the most risky. Thus, they assert that a significant proportion of these loans will not be paid back. In an attempt to maintain profitability, the lender must ration credit. The implication then is that the information asymmetry causes a 'market failure.' If there is a praxeologic explaination of why these particular loans (from the first quintile) are actually less risky I would certainly appreciate hearing it. I have a Macro Prelim exam tomorrow and I would love to have a bullet-proof explaination of how credit rationing could emerge as an institutional feature of competitive markets. Thanks for your help.


Loanable funds are a

Loanable funds are a resource, and having more of any resource is always better for an economy.

Absolutely. More resources are better. But it doesn't mean the owners of those funds will or should loan them out. An owner of a large resource can either save it, use it, or loan it. If the only people looking to borrow are in fact poor risks, it might be smarter to save the resource, or maybe even use the resource.

"The scarcity of loans has a

"The scarcity of loans has a positive benefit to the economy, as it serves as a gatekeeper, turning away marginal potential debtors."

And I suppose the scarcity of food is a good thing because it will keep some people from becoming obese?

Loanable funds are a resource, and having more of any resource is always better for an economy.

Your post reminds me of a different analogy: a business professor once did a study of fast-food restaurants and found that managers were overemploying people – often there were so many workers that they were literally bumping into each other and slowing down the process (i.e., marginal returns had not only diminished but actually gone negative). I think that's closer to the point you’re trying to make, but it only applies at the micro level; at the macro level having more people available to work is always better for an economy’s total output, assuming free markets, rational actors and good information flow.

Your post seems to suggest that irrational actors dominate rational actors and therefore it is good that their potential irrationality is constrained. But I see little if any evidence of that in the real world.

Kip, Loanable funds are a


Loanable funds are a resource, and having more of any resource is always better for an economy.

Isn't this the same as telling the Treasury to fire up its printing presses?

Your post seems to suggest that irrational actors dominate rational actors and therefore it is good that their potential irrationality is constrained. But I see little if any evidence of that in the real world.

I can't identify any irrational actors in my post. There are a range of entrepreneurs with greater or lesser abilities to predict and satisfy the preferences of consumers. There are bankers who must attempt to maximize their profits in whatever loan market they face.

Regards, Don

The existence of real

The existence of real capital resources is an unmitigated good. The existence of loanable funds is not. The more loanable funds there are, the greater the demand for existing capital goods, and the more likely that some of these resources will be wasted on marginal enterprises. The point that Don was trying to make---and this is the heart of the Austrian theory of the business cycle---is that credit expansion which is not backed by real savings is harmful, because it increases the demand for real capital resources without increasing the supply.

Thanks to both of you. I never completely understood this before, but for some reason it all fell into place when I read Kip's objection.

This thread reminded me of

This thread reminded me of one of my favorite passages from Henry Hazlitt's Economics in One Lesson, chapter six "Credit Diverts Production"

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 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. Somethimes 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.

Now it is to A, let us say, who has credit that the banker would make his loan. But the government goes into the lending business in a charitable frame of mind because, as we say, it is worried about B. B cannot get a mortgage or other loans from private lenders because he does not have credit with them. He has no savings; he has no impressive record as a good farmer; he is perhaps at the moment on relief. Why not , say the advocates of government credit, make him a useful and productive member of society by lending him enough for a farm and a mule or tractor and setting him up in business?

Perhaps in an individual case it may work out all right. But it is obvious that in general these people selected by the government standards will be poorer risks than the people selected by private standards. More money will be lost by loans to them. There will be a much higher percentage of failures among them. They will be less efficient. More resources will be wasted by them. Yet the recipients of government credit will get their farms and tractors at the expense of those who otherwise would have been the recipients of private credit. Because B has a farm, A will be deprived of a farm. A may be squeezes out either because interest rates have gone up as a result of the governemnt operations, , or because farm prices have been forced up as a result of them, or because there is no other farm to be had in his neighborhood. In any case, the net result of government credit has not been to increase the amount of of wealth produced by the community, but to reduce it, because the available real capital (consisting of actual farms, tractors, etc.) has been placed int he hands of the less efficient borrowers rather than in the hands of the more efficeint and trustworthy.

Chad, If a banker has


If a banker has limited funds to loan, he must rank the potential recipients. Since the loan interest rate is effectively set by the supply and demand of the market, the ranking will most likely be done in terms of the banker's perception of the risk of default of the potential recipients.

This inherently means that the lowest ranked recipient to actually receive funds will be perceived as more risky by the banker as he has more loan funds to distribute.

Regards, Don

My apologies, then, for the

My apologies, then, for the misunderstanding and misattribution.

Eddie, I'll stick with what


I'll stick with what I said. Your extensions do not represent my views.


So the Austrian business

So the Austrian business cycle theory says (and here I'm wildly paraphrasing) that when money is too plentiful, it starts going to businesses that have no business being in business. And that's bad. Which is why easy credit is such a horrible thing.

Don, your example makes this point pretty well. I think your rhetoric suffers when you reduce it to "credit as an economic scarcity is a good thing", because that claim is much too small and obvious to be interesting. Credit is money; if money were not economically scarce then money would be useless as money. You hint at that with your reply about firing up the printing presses.

The interesting question isn't whether money should be in limited supply. The two interesting questions are 1) how limited should it be, and 2) how should it be limited?

An increase in the supply of

An increase in the supply of credit will lower prices, lowering the price of market clearance. While that means more debtors, it also means less risk (because of the lowered price of credit). To me, at least, I can't say whether that's good or bad.

- Josh