September 17, 2008

The Credo of Credit

by Samuel Gregg D.Phil.

It's over a year since the credit crunch began wrecking havoc throughout the global economy. Never before, it seems, have we been so aware of how dependent our economies are upon the willingness to lend and borrow.

Since August 2007, we have seen Lehman Brothers go bankrupt, the remnants of Bear Stearns indirectly salvaged with Federal Reserve funds, Merrill Lynch purchased by the Bank of America, and the Fed take a 80 percent stake in AIG (and provide it with a bridging loan). Freddie Mac and Fannie Mae have been taken over by the US government. Eleven federally-insured American banks have failed. A collapsing English bank has been nationalized by the British government.

Financial institutions in America and Europe have written off billions in losses. Thousands of financial-sector jobs across the world have been eliminated. People's careers have been shattered. Everyone is asking: "Who's next?"

Given this environment, it's not surprising that considerable anger has been directed against those who specialize in the credit business, especially subprime-lending, be it of mortgages or credit-cards.

No doubt, some predatory lending has occurred. We need only pick up the nearest newspaper to read about elderly couples on the brink of bankruptcy because they signed mortgage agreements that they either didn't understand or were never adequately explained to them by their financial advisors.

We should, however, remember that much subprime mortgage lending was to people hoping to make a killing in the housing boom that, to their misfortune, began imploding last year. Then there's the disturbing BasePoint Analytics report stating that almost 70 percent of mortgage early-payment defaulters made fraudulent misrepresentations on their original loan applications.

But why, some argue, should subprime-lending businesses exist in the first place? Aren't they financial traps for the poor and vulnerable? Don't they discourage prudent saving? There have even been calls for official caps on interest-rates offered by private lenders.

The difficulty with some of these critiques is that they often reflect fundamental misunderstandings of the nature of credit and its underlying moral apparatus.

Credit is about lending others the financial means - the capital - that most of us need at some point of our lives. Whether it's starting a business or buying a house, most people need capital. This means someone else such as a bank or a private lender has to be willing to take a risk. Yes, they do stand to profit if the mortgage is paid off or the business succeeds. But they also lose if a house is foreclosed or a business goes bankrupt.

Charging interest is how lenders maintain their loan's value and make a profit (the margins of which are much narrower than most people realize), thereby increasing the sum-total of capital available in a society. But it's also their way of calibrating risk: the higher the risk, the higher the interest-rate in order to compensate for the greater possibility of loss.

Now consider what would happen if interest-rate ceilings were imposed by government fiat. If lenders were prohibited from charging interest-rates commensurate to the risks involved, they would be unlikely to lend capital to entrepreneurs and businesses pursuing high-risk endeavors. Hence, many risky but wealth-creating and employment-generating activities would simply never occur.

Legislated interest-rate ceilings would also mean that some poor people would never have the chance to acquire the capital they might need, for example, to go to college, let alone begin developing a credit-record. Entire categories of people - recent immigrants, the urban poor - could be condemned to life on the margins.

But at a deeper level, such regulations ignore the fact that while credit is about capital, it is ultimately about something more intangible but nonetheless real.

The word "credit" is derived from credere - the Latin verb for "to believe" but also "to trust." Whether it's giving someone a credit-card for the first time, or extending a small business the capital it needs to grow into a great enterprise, providing people with credit means that you trust and believe in them enough to take a risk on their insight, reliability, honesty, prudence, thrift, courage and enterprise: in short, the moral habits without which wealth-creation cannot occur.

A moment's thought about credit thus reminds us how much market capitalism, so often derided as materialistic, relies deeply upon a web of moral qualities and non-material relationships. Once these are corrupted, whether by basic dishonesty or excessive regulation, the wheels of wealth-creation splutter and eventually grind to a halt. Businesses die, people lose their jobs, and families suffer.

Could there be a better demonstration that there can be no markets without morality?

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