Two Unspoken Assumptions in the Credit-Crisis Debate

In the heated, sometimes almost hysterical discussions and debates of the “credit crisis” now swirling through the press, the Internet, and the programs broadcast on radio and television, nearly everybody is making two, usually implicit assumptions:

    I. The volume of outstanding credit should never decline.
    II. If the volume of outstanding credit has declined, the government should act to reverse that decline.

Neither of these assumptions makes good sense.

With regard to the first assumption, it is possible that past increases in the volume of credit extended may have been excessive. Indeed, in certain markets, such as mortgage lending to unqualified borrowers, the credit extended in recent years certainly has been excessive. Taking seriously the concept of an “unqualified borrower,” we must admit that such loans ought never to have been made at all. As foreclosures proceed, the amounts of credit that mortgage lenders extended to unqualified borrowers in the past will be wiped away in the settlements. Likewise for loans made to firms currently in bankruptcy proceedings. These developments represent desirable adjustments to previous errors. To suppose that some compensatory lending should occur to offset these kinds of credit shrinkage makes no sense. There are good times for lenders to expand their loans, and good times for them to retrench.

In view of what I have just said about Assumption I, little need be said about Assumption II. If credit retrenchment is occurring for good reasons, then the government’s actions to offset this retrenchment are unnecessary, and most likely they will be mischievous, as well. Government loans or loan guarantees will serve to prop up borrowers who ought never to have received the loans in the first place. Firms that ought to go out of business will continue to operate, and thus continue using resources that actually have greater value in alternative uses. The economy’s overall efficiency is thereby diminished, and the foundation is laid for the recurrence of similar troubles at a later stage.

Robert Higgs is Senior Fellow in Political Economy at the Independent Institute, author or editor of over fourteen Independent books, and Editor at Large of Independent’s quarterly journal The Independent Review.
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