The Theory of Business Enterprise
Chapter 5: The Use of Loan Credit
Thorstein Veblen
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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
(93) 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
(94) 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
(95) 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]
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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 régime
(97) 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;
(98) 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
(99) 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
(100) 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
(101) 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
(102) 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. Pro-
(103) -perty 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,
(104) 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(105) 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
(106) 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
(107) 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
(108) 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 inflation 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 out-
(109) put 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(110) 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]
In a period of liquidation this potential ownership on the part of the creditors takes effect toloans/capitalization (=collateral + loans)
(111) 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
(112) 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 indus-
(113) -trial 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,
(114) 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)(115) 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
(116) 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 busi-
(117) -ness 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]
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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 greater 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
(119) 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 organization, 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(120) 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
(121) 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 modem 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
(122) 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.
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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 indeter-
(124) -minate, 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
(125) 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
(126) 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
(127) 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 de-
(128) -scriptions) 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
(129) 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
(130) 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 promoter, 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 common 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)
(131) 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 magnitude 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 magni-
(132) -tude 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.
