This section is from the "Elementary Principles of Economics" book, by Richard T. Ely and George Ray Wicker. Also available from Amazon: Elementary Principles Of Economics: Together With A Short Sketch Of Economic History
What Credit Is. We have seen the immense development in exchange that has been made possible by the use of money, a development resulting in the division and organization of labor and a revolution of the whole economic life. Yet money alone as a medium of exchange is entirely inadequate to explain the magnitude of present commercial transactions. Great as is its advantage over barter, money is too clumsy an instrument for many modern purposes. While it is by no means dispensed with in our own day, money is primarily characteristic of the economic stage preceding our own. The characteristic instrument of exchange in our day is not money, but credit.
Like so many other terms which economics borrows from the language of everyday life, the word " credit" has many meanings and shades of meaning. One of the commonest of these is indicated when we say that a man's credit is good or that he has good credit, by which we mean that he has the reputation of paying his debts and has the ability to do so, and that therefore other men are willing to sell him goods and to wait for their pay until a future period. Another important meaning of the word refers to the character, not of the man, but of the transaction itself. The transfer of goods with the expectation of future payment is a credit transaction. This is the idea which we embody in the word " credit" in the science of economics. We may therefore define the term as follows: A credit transaction is a transfer of goods for a promise of a future equivalent. First, it should be noticed that the transaction is partly present and partly future, or, in other words, credit contains an element of time. In the second place, it is to be remarked that the transaction involves confidence either (a) in the character and resources of the borrower or (6) in the sufficiency and security of goods which he may have pledged for the fulfilment of his promise. A third factor frequently present is a written evidence of indebtedness, given by the borrower to the lender. This writing constitutes the instrument of credit.
The Mechanism of Credit. The mechanism of credit, or the machinery by which credit operations are carried on, consists of two parts: (I) the instruments of credit, the evidences of indebtedness, such as checks, drafts, notes, bonds, etc.; and (II), the institutions of credit, consisting principally of banks and clearing-houses.
I. Instruments of Credit. Among the instruments of credit the simplest and most extensively used is the (1) check. A check is an order upon a bank by an individual or company requiring the payment of a certain sum of money to the order of a person named or to the holder of the check. In this form of credit the element of time plays a very small part. If money were paid instead of a check, the person receiving it would be likely to deposit it in a bank. Receiving a check, he carries it to the bank. The element of credit here prominent is the trust or confidence involved, the confidence that the check will be honored by the bank upon which it is drawn.
Bankers also use checks. When one banker gives a check on another, the instrument is usually called a (2) draft. Another form of draft arises when a bank or a company or an individual orders the payment of a sum of money to a bank. When, however, the drawer and drawee of a draft live in different countries, the instrument is often called a bill of exchange. Both these terms are so loosely and variously used that the reader must usually judge a writer's meaning from the context.
A third form of instruments of credit consists of (3) notes, which are usually 'promises to pay a certain sum of money for value received, under conditions named, on demand or at the expiration of a certain period. Here the time element is important, and is recognized by the payment of interest. Such notes are of three general kinds, according to the character of the maker, (a) Individuals and companies issue promissory notes for payment on demand or within a certain time. (6) Banks in most countries issue notes which commonly pass as money and which have a different legal standing than belongs to the notes of individuals. Such are the national bank notes of the United States, (c) Governments themselves often issue notes such as those which we have already discussed in treating of the subject of paper money. Bank notes and government notes do not usually bear interest.
Ordinary instruments of credit do not circulate freely like money, but are intended to be used primarily in one transaction ; yet they are by no means confined to this. Thus checks and drafts often pass through many hands, and notes are often transferred once, twice, or many times. With bank notes and government notes, however, which circulate as money, the case is quite different. These are (1) intended for general use ; (2) they are always drawn to bearer; (3) they are issued in fixed and convenient denominations; and (4) the credit of the issuing agent is usually taken as a matter of course.
Credit transactions between individuals usually take one of the two following forms: (1) usually a person buying goods promises to pay the person from whom the goods are bought; but, instead, (2) the seller may " draw on" the buyer by means of a bill of exchange which in such cases is also sometimes called a draft, if both parties to the exchange reside in the same country. Let us suppose that A is the seller and B a buyer in a distant place. A writes an order upon B to pay to him or to a third party, C, the amount of the debt. If B on receipt of the order acknowledges the debt and is ready to agree to pay it, he writes accept on the bill and signs his name. This act is called an acceptance. The instrument thus becomes legally binding upon the acceptor.
Checks and notes may be transferred by indorsement. The payee, by writing his name on the back of the instrument, orders the payment of the money to another person whom he names in writing. By thus indorsing the instrument, he becomes responsible for its payment in case the one who precedes him in responsibility fails to make the payment. The person to whom such an instrument is indorsed, or the indorsee, may also in turn become an indorser, in which case he also assumes similar responsibility.
Book credit (4) is another form of credit which is extensively used, especially in retail trade. When goods are sold, a record is kept, or, as we ordinarily say, the goods are " charged," a bill for the amount being sent at a later time. Where two persons mutually grant book credit, as is often the case among merchants in small places, only balances need be paid in money on settling day.
II. Institutions of Credit: Banks and Clearing-houses. Bankers have already been mentioned as middlemen in credit transactions. They are sometimes called dealers in credits, and indeed there is little that they do which is not in one way or another connected with credit. But banks are not mere agents. They have a capital of their own which serves as a guarantee fund, and they receive money which customers deposit with them. Under legal regulation they mingle the deposits with their own capital and have exclusive control over it all. They are debtors of their depositors, and creditors of those to whom they lend money. Their source of profit is not exclusively nor even chiefly their own capital, but rather the funds deposited with them. As a rule, commercial banks either pay no interest on deposits or they pay interest at a rate considerably lower than that charged on money loaned, the difference constituting their chief source of profit.
In earlier times nearly all banks in the United States issued notes which circulated as money. Indeed, such note issues were commonly regarded as the principal business of banks. Now only national banks are able profitably to issue notes, and they are required to deposit bonds at Washington as security for the circulation, besides paying a special tax for the privilege. In nearly all civilized countries, the power of banks to issue circulating notes has been greatly restricted, and the number of banks that find a source of profit in such issue is constantly diminishing.
It would take us too far afield were we to enter upon a complete discussion of the various kinds of banks and their precise differences. Briefly, we may say that any institution that (a) discounts notes or other forms of commercial paper, and (6) receives and holds deposits, is a commercial bank, whether or not it issues notes, and whether or not it is incorporated by law. When the word "bank" is used alone it always refers to such an institution. Savings banks are therefore not banks in the legal sense of the word. The three classes of regular banks in the United States are our national banks, numbering about 4500; state banks, which with trust companies number about 4500; and private or unincorporated banks, which also probably number about 4000. Trust companies, which are of recent development and of rapidly growing importance, are incorporated institutions differing little from banks. In fact, many bankers insist that the business done by the larger proportion of the great trust companies is a strictly banking business, and that this fact should be kept in mind by legislators and administrators. At present such companies seem to enjoy most of the privileges granted to incorporated banks, without being compelled to observe the restrictions by which banks, as the result of experience, have been surrounded. Within the last decade this condition of comparative irresponsibility has made it possible for such companies to invest in doubt-ful securities and thus to help in the " flotation " of unsound industrial enterprises. It would seem to be advisable that trust companies should be subjected to supervision at least as rigorous as that which is provided for national banks by the Federal law.