Recently a House member (Ocasio-Cortez) questioned a banker in a hearing about why his bank (Wells Fargo) should not have to pay if a pipeline company to whom it made a loan had a pipeline leak. Alfredo Ortiz understands why not. He understands what Rep. Ocasio-Cortez does not:
“Ocasio-Cortez’s point betrays a total naïveté about how financing works. Her contention is akin to claiming that a bank holding a car loan should be responsible if the owner gets into a crash. It’s like saying a bank holding a home mortgage should pay to fix the pipes when they burst.
“The socialist congresswoman misunderstands the role of credit in the economy. Credit exists to match capital to its most highly valued use. For entrepreneurs and small businesses, this means matching capital in search of ideas with ideas in search of capital. The United States’ deep and liquid capital markets are a major reason for its economic productivity and success.”
Countries that do not develop markets for capital remain in primitive form. Credit instruments are essential for productive operations to occur at a high and intense level. Manufacturing requires capital, and capital must be raised. Financing is essential.
There are many credit instruments. They vary in maturity and risk. A person who saves can buy very safe AAA bonds or various less safe credit instruments, down to highly speculative junk bonds. The financial markets break down the risks of a business or an operation or a project. They repackage these risks into a variety of loan types. It’s like white light being broken down into a rainbow of colors.
This process selects a financing structure that suits the operations being financed. Longer-term assets, like a railroad, are suited to longer-term bonds lasting years. Shorter-term operations, like producing seasonal crops, are suited to short-term loans. Within maturity, many other finely-tuned features can be found, like sinking funds and call provisions. These are designed to suit the projects and the lenders simultaneously. Lenders can find loans to make across this spectrum, and as they specialize this lowers the cost of capital to the borrowers.
Overall risks do not disappear, but they are repackaged into pieces that are appropriate to control the borrowers who receive the financing. The goal is to lower agency costs and assure that the capital is properly directed to the promised ends.
Economics courses do not usually teach finance or the details of these matters. That’s a separate specialty taught in business schools. Within finance, there are further sub-divisions of study, such as investments, financial markets, banking and business (corporate) finance, and personal finance.
Most people do not understand credit markets, even those who have taken an economics course. The study of finance as a science is relatively recent, mainly dating from about the 1950s. Understanding the reasons for credit markets and the different kinds of innovative credit instruments is an ongoing challenge.
Ortiz correctly writes “Credit exists to match capital to its most highly valued use.” This involves inventing the types of financial instruments we observe. These are contractual in nature. This entails spelling out legal liabilities and actions to be taken in the event of failed projects or other contingencies. This is a central feature of a capitalist economy that is productive. Enterprises simply do not go forward if they have to rely upon primitive means of finance or financial means unsuited to the borrowers and lenders.
Borrowers cannot attract loan capital if the lenders are held responsible for the operations. The whole idea of a loan is that it insulates the lender from such operational liability. But loans do carry default risk, and lenders do insert provisions to control the borrowers so that their interests are aligned in seeking to avoid failure.
Owners who operate projects finance them in part by equity, that is, a direct ownership interest. Lenders have contingent claims and a distinctly different liability interest. This division of responsibility allows the owners to obtain loan finance, and at the same time allows the lender to avoid being an owner. This much, at least, is taught in economics courses. Even this much knowledge, however, was not evident in Ocasio-Cortez’s questions. She was intent on putting the banker in the hot seat because she wants government to control and allocate credit. This would, if carried out in depth, destroy financial markets as we know them, destroy a central feature of capitalism, and rapidly undermine business productivity in this country.
Communists like Ocasio-Cortez are so ignorant that they do not even know the economic problems that faced their communist predecessors. “Democratic socialists” are ignorant communists who seriously claim that democracy will solve all economic problems.
9:42 am on March 16, 2019
