UNDERLYING FORCES
SHAPING THE BUSINESS CREDIT MARKET,
1900-1940
THE BUSINESS CREDIT MARKET after 1900 was influenced by nu-
merous forces which may properly be described as underlying in
nature and pervasive in effect. Some of these forces have been dealt
with above, primarily in Chapter 3 : long-term changes in the rela-
tive importance of enterprises of different size and industrial char-
acter j long-term shifts in the relative importance of different types
of assets held by nonfinancial business concerns - y and certain dis-
cernible shifts in the policies and practices of concerns with respect to
the way in which their assets are financed. These long-term changes
were considered in Chapter 3 because of their immediate relation to
changes in the business credit market, which it was the purpose of
that chapter to describe. The present chapter will discuss certain
salient trends in the American economy which, while somewhat less
directly related to the business credit market, had profound and
lasting effects on that market.
The basic underlying forces selected for discussion include:
1 i ) The growth factor in the American economy, somewhat re-
tarded during the early twenties and definitely interrupted in the
thirties
(2) The marked increase in the ratio of capital to labor in many
important sectors of the economy
(3) The fairly persistent increase in the relative importance of
the output of consumer durable goods
(4) The persistent and, to a certain extent, growing instability
of business activity
(5) The expansion of government as an agency of capital for-
mation
(6) The decline of interest rates, particularly after 1930.
152
UNDERLYING FORCES 153
In some cases these factors were, to a great extent, independent of
the banking and credit system proper j in others, changes in the busi-
ness credit market and in these underlying factors were mutually
dependent. Thus, credit conditions affected, as well as were affected
by, fluctuations in business activity} and the declining trend of inter-
est rates may be viewed as a change in the business credit market it-
self. This distinction between factors mainly independent of the
banking and credit system and other, interdependent, factors is a
useful one to bear in mind. Another useful distinction is that be-
tween long-term trends, such as those in population and produc-
tion, and short-term fluctuations, such as changes in prices and
profits, which exerted profound influences on the business credit
market.
ECONOMIC GROWTH
Growth in the American economy after 1900 was at different rates
in different periods, but the over-all result was one of tremendous
expansion, as is clearly shown by the several measures of economic
change presented in Chart 25. First of all, population nearly dou-
bled between 1900 and 1940, with the rise more rapid in the first
half than in the second half of the period. Beyond this, important
internal shifts in population distribution, which are closely related
to economic growth, took place. The urban population increased
from about 30 million people in 1900 to nearly 75 million in 1940,
while the rural population remained comparatively stable, rising
from 46 to 57 million. Thus the population distribution as between
town and country was wholly reversed in forty years.
Paralleling the growth in population was the growth in the labor
force. Various estimates of the numbers in the labor force show
marked discrepancies, since they were derived in different ways,
but the same general pattern is apparent in all. The estimates of the
National Industrial Conference Board (Chart 25) reveal a rate of
growth almost exactly the same as that of the total population. Any
over-all series on the labor force, however, veils important shifts in
the distribution of employment by industries. For example, be-
tween 1900 and 1929 the proportion of the working population
engaged in agriculture dropped from 35 percent to roughly 22 per-
cent. Workers in industry, on the other hand, increased from 37
154
BUSINESS FINANCE AND BANKING
Chart 25 MEASURES OF GROWTH IN THE AMERICAN
ECONOMY, 1900-1940
(logarithmic vertical scale)
United States Population
(in millions)
Manufacturing Output
1 (1699-ioV
'20 '25 '30 '35
1900 '05 '10
The dominant factor in the American economy
from 1900 to 1930 was persistent growth. Dur-
ing the early thirties, the growth factor was ab-
sent; by most measures, the recovery of the late
thirties did no more than approach the high levels
of the twenties.
percent to around 40 percent} in trade and finance, from 12 percent
to 17 percent} and in service industries, from 14 percent to 19 per-
cent. When these data are carried forward to 1 940, the only signifi-
cant change beyond the pattern established by 1929 is a further
increase to slightly over 22 percent in the proportion em-
ployed in the service industries.
The participation of increasing numbers of people in the process
of production was accompanied by an even greater growth in the
output of manufacturing industries, although this was interrupted
in the thirties. After a sharp decline from 1929 through 1932 out-
put increased again, but in 1939 ^ was on ty slightly above its 1929
peak.
Estimates of national income and wealth also record substantial
UNDERLYING FORCES 155
growth during the first three decades of the century, and then a de-
cline. Although increases again occurred after the early thirties, the
levels reached were not so high as those attained in the twenties.
The rates of growth of national income and wealth were consider-
ably above that of population, meaning that per capita income and
wealth increased. This fact is important in the present study, because
the continuing improvement in the economic welfare of the average
American consumer, which it reveals and which was reflected in his
consumption habits, is of peculiar significance to credit develop-
ments.
The business credit market, like other segments of the economy,
experienced a considerable expansion from 1900 to 1930 and an in-
terruption of that expansion in the thirties (Chart 26). 1 Rough
approximations of the magnitude of the long-term credit market
(measured by changes in corporate bonds outstanding) 2 and of the
short-term credit market (measured by changes in private short-
term debt and, prior to 1916, by the trend of total bank assets) 8
indicate that each element increased fivefold during the first three
decades of the century. In the thirties, however, when the long-
term credit market held close to the level attained by the late twen-
ties, the short-term market contracted more sharply than any other
1 Not all the measures that are needed to trace changes in the magnitude of the
business credit market are at hand, and some that are available cover more than the
business element in the credit market j but information is fairly complete from 1916,
and inferences can be made from other materials for the earlier years. Such broad
measures as can be obtained are grouped in Chart 26.
2 Quadrennial estimates have been made by the Corporate Bond Project, National
Bureau of Economic Research, Financial Research Program. These data indicate that
corporate bonds outstanding increased from $6.1 billion in 1900 to $33.4 billion in
1932$ after a very moderate decline during the thirties, the total stood at $27.1 billion
in 1940. Other estimates of long-term business debt are available and, while they differ
from the above in amount, they reveal almost exactly the same rates of growth and re-
tardation over comparable periods. These estimates are the National Industrial Confer-
ence Board series on the outstanding corporate debt of steam railroads, public utilities,
and industrial corporations, 1900-1942 (The Economic Almanac for 1943-44,
p. 383), and the series on net private long-term corporate debt, 1916-42, compiled by
the Department of Commerce (Survey of Current Business, July 1944, p. 16).
8 The nearest approach to an estimate of the short-term business credit market is a
Department of Commerce series on private short-term debt for 1916-40. On the
assumption that this can be taken as a fair indication of the direction and extent of
change in business short-term debt for these years, the short-term business credit market
can be said to have doubled from 1916 to 1929. Changes from 1900 to 1916 can be
judged only from the trend during those years in total bank assets. Under the assump-
tion that the relation between the two series which prevailed in 1916-29 also charac-
terized the period 1900-1916, private short-term debt in 1900 may be estimated at
something under $10 billion.
The business credit market, like the economy as a
whole, was constantly expanding in the first three
decades of the century. Long-term business debt
stabilized in the fourth decade, while short-term
debt decreased.
sector of the economy. Contrary to the behavior of most other
series, net private short-term debt failed by 1940 to regain its 1929
level.
Accompanying this spectacular over-all expansion in the dimen-
sions of the business credit market was an expansion in the facilities
and resources of the commercial banking system. In 1900 there
were 8,738 commercial banks incorporated under national and state
banking laws, and 5,187 unincorporated private banks, a total of
13,925. By 1920 this total had more than doubled, but then a
rapid decline began and in 1933 the number was about the same as
in 1900. This decline reflected in part bank consolidations after
1920 and in part the closure of banks, particularly in rural areas.
The 1933 number was maintained with only negligible change
through 1 940. A more adequate series for revealing the growth of
UNDERLYING FORCES 157
the commercial banking system is total bank assets. By this measure,
bank resources expanded over sixfold from 1900 to 1940; only in
the thirties did a significant interruption occur, and this was tempo-
rary. Over the whole period there was a remarkable increase in the
assets held by the average bank.
How did the underlying force of economic growth affect the busi-
ness credit market, aside from the effects obvious in the above meas-
ures of the market's expansion and decline? The most important
effect from the point of view of the present study was the change in
the competitive conditions of the market, caused by the shift from
fairly regular expansion during the first three decades to the con-
traction and partial recovery of the fourth. During the early
period, when the total demand for business credit was growing more
or less persistently, there was little basis for inter-agency competi-
tion. This condition was wholly altered, however, when the under-
lying growth factor was lost; each agency was faced with increasing
problems of competition, as its assets grew and the demand for
private business credit declined. It is not surprising, therefore, that
some of the most striking institutional changes in the business credit
market appeared in the fourth decade of the century.
Specifically, the contraction of the business credit market during
the thirties, and the consequent necessity for business financing
agencies to use new methods of financing or to reach out into new
credit fields, if they were to hold their own, forced the initiation and
spread of new lending techniques. As indicated in earlier chapters,
these occurred in three main areas consumer instalment credit,
intermediate-term credit to large and medium-sized business enter-
prises, and newer types of secured credits to small businesses
all of which, while they constituted new areas of lending for com-
mercial banks, were areas in which other agencies were already
functioning. The result was heightened inter-agency competition.
Economic growth also affected the conditions under which the
business credit process was conducted. During the first decade of the
century business was conducted in the main through enterprises of
relatively small unit size; some of these were national organiza-
tions, but in most instances operations were relatively limited in
geographical scope. Further, the market situation in which they
operated was far less complicated than it became in later years. Eco-
nomic growth meant not only an increase in the average size of the
158 BUSINESS FINANCE AND BANKING
business unit and of the commercial bank, but also an increasingly
complex set of market conditions; the whole process of business
management became institutionalized and depersonalized through
the agency of the large corporation. In consequence, the task of
credit appraisal grew more complicated and less amenable to prac-
tice on the basis of personal relationships.
INCREASING RATIO OF CAPITAL TO LABOR
IN PRODUCTION
Technological progress resulted in a marked increase in the ratio of
capital equipment to direct labor in the productive process. This de-
velopment can be measured in a number of ways, but for present
purposes its extent may be indicated by reference to two measures:
the ratio of "capital assets" (net of land) to the number of wage
earners employed in manufacturing industries, and the proportion
of fixed assets to total assets for the samples of corporations ana-
lyzed in Chapter 3. The first measure, shown in Chart 27, reveals
that capital assets (net of land) per wage earner in manufacturing
as a whole increased by 264 percent between 1904 and 1937. Of
course, there were considerable differences in the extent of change
among industrial subdivisions; increases were especially marked in
petroleum refining, where capital assets per wage earner in 1937
were eleven times as great as in 1904, whereas the ratio for leather
products remained constant over the period. Output per worker,
which is a rough and indirect reflection of the use of capital equip-
ment, expanded between 1902 and 1939 by 180 percent in mining,
including oil and gas, and by 94 percent in manufacturing. In agri-
culture an increase of 64 percent occurred between 1900 and 1937.
The effects on business credit demands of more intensive use of
capital in production may be summarized briefly. First, by increas-
ing the optimum size of individual concerns as measured by total
assets, the development meant that a higher proportion of business
was done by larger concerns. As indicated above, the larger enter-
prises tended to depend less than small concerns on the banks for
funds. Second, the greater importance of fixed assets relative to
current operating assets, as shown in Chapter 3, had the effect of
placing increasing emphasis on long-term as contrasted with short-
term funds. Thus the industries that showed a greater than average
Iron and Steel Products !!:::::>
Chemical and Coal Products
Foods :::::.
Printing and Publishing :::::>
Electrical Machinery
Textile Products (
Beverages KVX
Machinery Other Than >:>:*>:
Electrical
Leather
Products
Those manufacturing industries that experienced the greatest rela-
tive increases between 1904 and 1937 in the amount of capital as-
sets utilized per wage earner were in general the least dependent on
bank credit as a means of financing in 1937.
160 BUSINESS FINANCE AND BANKING
increase in capital assets per wage earner were, in 1937, generally
less dependent on bank credit than those industries with a less than
average increase. Third, the use of specialized capital equipment
changed the character of credit demands. Increasingly, credit de-
mands grew out of the acquisition of specific items of equipment,
especially among manufacturing, trade, and service concerns of
small and medium size. These demands meant not only an expand-
ing market for medium-term credit but also the assumption of rela-
tively high risks where the debtor was of only moderately good
credit standing and where a lien was held on equipment susceptible
to a high rate of depreciation. Finally, by increasing the potential
(and actual) variation in annual business investment expenditures,
the rising ratio of capital to labor contributed to the instability of
the economy with consequences that will be discussed in a subse-
quent section.
ENLARGEMENT OF USE OF CONSUMER DURABLE GOODS
Another reflection of the technological progress and higher stand-
ards of living achieved during the twentieth century was the in-
crease in the relative importance of consumer durable goods, com-
pared with those of a semi-durable and perishable nature. While
the value (in current prices) of the output of these last two groups
of commodities increased about four times between 1900 and 1939,
the value of the output of finished consumer durable goods ex-
panded more than seven times. The most marked difference in
growth, as shown in Chart 28, occurred in the twenties when the
rate of output of durable goods increased rapidly while produc-
tion in the two other categories increased only moderately or not at
all. It is significant that the change in consumer durable goods was
due mainly to greater output of new commodities and not to in-
creased production of older types of goods.
The growth in the importance of consumer durables had two im-
portant effects upon business credit demand. First, the altered struc-
ture of consumer expenditures which it implies, with greater
emphasis on expenditures on durable commodities, increased both
the potential and actual degree of variation in annual consumer
outlay. Chart 28 shows that instability was greatest in the output
of durable, and least in the output of perishable, goods. By contrib-
The value of output of consumer durable goods
increased more than sevenfold from 1900 to
1939, contrasted with the fourfold increase of
other types. Wider use of these high-unit value
goods laid the basis for the development of con-
sumer instalment financing.
uting to instability in the economy, the shifting composition of the
flow of consumer goods produced consequences similar to those
traceable to a rising ratio of capital assets to labor. Second, the in-
crease in the relative importance of the durable goods component of
total consumer goods output during the twenties was due mainly to
increased output of automobiles, household appliances, and radios,
each of which is a commodity of high unit value and commonly pur-
chased on an instalment basis. The greater demand for such goods
laid the basis for the rapid development after 1920 of the sales
financing industry and the later participation of commercial banks
in consumer instalment financing.
The implication of this second effect for the institutional struc-
ture of the credit market has already been noted: whereas commer-
cial banks were extending virtually no credit to finance companies
in 1920, such loans had increased by 1939 to the point where they
162 BUSINESS FINANCE AND BANKING
nearly equaled total bank loans to manufacturing concerns. It was
estimated that loans to finance companies in 1939 amounted to $1,3
billion, and those to manufacturing concerns to $1.6 billion, out of
an estimated total of $5.1 billion of short-term loans to commer-
cial and industrial enterprises. To this sizable quantity may be
added direct consumer instalment financing by banks, which was
estimated as $1.0 billion at the end of 1939 or about 6 percent
of total loans and discounts and 17.5 percent of commercial and
industrial loans held by all banks. If the two types of financing
loans to finance companies and direct loans to consumers are
combined, the total equals nearly 14 percent of total loans and dis-
counts of commercial banks at the end of 1939.
INSTABILITY IN BUSINESS ACTIVITY
Both the increasing ratio of capital to labor and the greater rela-
tive importance of the durable goods component of total consumer
goods output tended to make the economy potentially and actually
more unstable, and thus influenced the business credit market. The
increasing instability in business activity after 1900 is shown by data
on the physical output of manufacturing industries. As indicated in
Chart 25, production after World War I was disturbed by three
major setbacks} two of these (in 1920-21 and 1937-38) involved
a loss of about 20 percent each, and the third (1929-32) a loss
of nearly 50 percent. By contrast, during the decade and a half pre-
ceding World War I the four years in which the index of manufac-
turing output was lower than in the preceding year, namely 1904,
1908, 191 1, and 1914, the percentage declines in the index were 6,
17, 4, and 6 percent, respectively. A similar record of increasing in-
stability is provided by data for bank clearings outside New York
between 1882 and 1936.
Data on the sales and profits of business concerns do not extend
sufficiently far back to support generalizations concerning changes
in the degree of instability in economic activity. Measures that are
available, however such as sales of samples of manufacturing
and trade corporations from 1915 to 1940 and ratios of net income
to net worth, also based on sample data reflect the highly un-
stable market background against which credit extending agencies
have functioned since 1915.
UNDERLYING FORCES 163
The primary effect on the business credit market of economic
fluctuations was to increase the risk inherent in the credit-granting
process. Consequently, the serious fluctuations in the 1920*5 and
1930*8 tended to encourage both borrowers and lenders to take an
increasingly cautious view of the financing process. On the part of
the borrower, cyclical fluctuations stimulated the desire for as large
a measure of independence from external sources of funds as pos-
sible, placed a greater premium on ownership than on debt funds
where external financing was required, and suggested the use of
relatively longer-term loans so as to minimize the contingency of
having to repay loans at a time when the concern's general finan-
cial position was worsened by successive years of losses or of rela-
tively low earnings.
From the viewpoint of the financing agency, the occurrence of
business depressions, and especially the continuance for some years
of low levels of activity and profitability, had a serious effect on risk
conditions. Successive annual deficits among the small and medium-
sized concerns that comprised the majority of business loan borrow-
ers caused a reduction of their capital and general weakening of
their financial condition and credit standing. To operate satisfacto-
rily under such circumstances lending agencies had to have recourse
to various types of risk-limiting devices. This underlying factor
was responsible in large part for the development and wider use
during the thirties of such devices as those described in Chapter 5,
namely, the assignment of accounts receivable, warehouse and trust
receipts, and liens on equipment.
The second major effect of economic fluctuations on the business
credit market is found in the enlargement of public controls over
credit extending activities. The framework of law and regulation
within which commercial banks operated as business lending agen-
cies was dictated in large part by the necessity, as the legislatures saw
it, of preventing banks from exposing themselves to certain risks
associated with economic instability. Thus, the limitations found in
the national banking laws with respect to loans made on real estate
and the security of stock exchange collateral, and to investment in
equity securities, are examples of social controls the purpose of
which is to restrain banks from excessive participation in types of
lending and investing peculiarly susceptible to loss during periods
of business recession.
164 BUSINESS FINANCE AND BANKING
Finally, after 1929 prolonged underemployment of resources
became the basic factor underlying the rise of government agencies
prepared to lend directly in the business credit market, or to assume
some of the risks involved in credits extended by private agencies.
The industrial lending activities of the Federal Reserve banks and
the Reconstruction Finance Corporation and their risk-sharing pro-
grams developed out of depression conditions. Also, the insurance of
home mortgages and of home modernization loans under the
Federal Housing Administration was intended primarily to stem
the tide of business recession and to encourage private lending
agencies to expand their activity in the field of home financing.
EXPANDING ROLE OF GOVERNMENT IN
CAPITAL FORMATION
A development of fundamental importance to the business credit
market in the period under review was the steady increase in the
role of government in capital formation. By supplying an ever-
widening range of services and developing natural resources, gov-
ernment enlarged the part it played in the productive activity of
the community, and correspondingly in the financial system.
A rough index of this development is provided by data for pub-
lic construction as a percentage of gross capital formation (Chart
29). This index reveals a steady increase in the importance of public
capital formation during the twenties and a very sharp rise in the
early thirties, attributable mainly to the fact that private capital
formation declined more than public construction. While data on
capital formation in later years were compiled on a somewhat dif-
ferent basis, and therefore are not strictly comparable with those
for the earlier period, they show quite clearly that toward the end
of the thirties the ratio of public construction to gross capital forma-
tion was nearly four times as great as at the end of World War I.
Associated with this underlying trend was a complete reconsti-
tution of the asset structure of the banking system. At the close of
World War I, government securities of national banks comprised
about 1 6 percent of total assets j at the outbreak of World War II,
the proportion was about 30 percent (Chart 29). The change, how-
ever, cannot be explained by reference exclusively to the rising pro-
portion of public construction to gross capital formation. Two addi-
Increased bank holdings of government debt in the thirties were associ-
ated with a higher proportion of public construction to total capital
formation and with federal deficits.
tional conditions were important. First, the federal government
operated with a net surplus of receipts over expenditures from 1920
to 1930, inclusive, and there was a substantial decline in the federal
debt, offset for the most part by an increase in state and local govern-
ment debt. In those years the proportion of government obliga-
tions to total bank assets remained roughly constant. Beginning in
1931, however, the federal budget showed a deficit every year}
current expenses as well as expenditures on public construction gave
rise to an increasing federal debt, a substantial part of which found
its way into the commercial banking system. In sharp contrast, the
rate of expansion of the assets of business enterprises was greatly
166 BUSINESS FINANCE AND BANKING
curtailed during the thirties, as was revealed in Chart 20, Chapter
3. Because of its low rate the asset expansion of private business
which did occur was, to a higher degree than formerly, financed out
of funds acquired internally and without extensive recourse to the
financial markets. It was mainly the combination of these condi-
tions in the thirties the expansion of public, and the contraction
of private, external financing needs which produced the altered
asset structure of American commercial banks. As will be seen in
Chapter 7, this change in bank asset structure, clearly evident by
1940, was furthered by the economic and financial conditions of
World War II.
DECLINING INTEREST RATES
The declining trend of interest rates, particularly after 1930 a
circumstance of the credit market itself was also a factor affecting
business financing conditions. As shown in Chart 30, the ratio of
total interest and dividends on securities to total security holdings
declined from 4.1 percent in 1931 to 2.1 percent in 1940, while a
comparable ratio for loan assets fell only from 5.0 to 4.2 percent.
The combined result was to lower the earnings ratio for member
banks from 4.2 to 2.3 percent, in sharp contrast to the preceding
decade, when bank earnings remained roughly constant.
The primary effect on the business credit market was to inten-
sify inter-agency competition and to induce changes in bank lending
policies and techniques. The extension of bank activity into areas
formerly served almost exclusively by specialized nonbank agen-
cies has been described in earlier chapters. The fact that these insti-
tutional adjustments took place in the thirties and not in the twen-
ties may be explained in large part by the different levels of bank
earnings in the two periods and by the growing discrepancy between
earnings on loans and earnings on investments.
Closer inter-agency competition and the necessity of following
new lending policies and credit techniques were particularly marked
in two separate but related developments: direct participation in
the consumer instalment credit market and more extensive exploita-
tion of the business credit market. The competitive conditions caused
by the former development are well known. The latter took two
forms, with quite different competitive results. First, commercial
banks attempted to raise earnings
by extending their activities in the
intermediate-term credit market
where, as a rule, interest rates on
long-term loans to a given quality
of borrower were higher than
rates on short-term loans. This was
not true of all borrowers, but it
may be observed that after 1930
the basic short-term yields on debt
obligations fell increasingly below
the long-term basic yields, whereas
from 1900 to 1930 the former
had, in all but two years, been
either equal to or greater than the
latter. 4 This policy of making
longer-term advances of credit in-
tensified competitive conditions
between banks and insurance com-
panies and, through the device of
private placement, affected rela-
tions with investment banking
firms. Second, loans carrying
somewhat higher risks and corre-
spondingly higher rates of return
were accepted, which meant, in al-
most all cases, a more extensive ex-
ploitation of the financing needs of
small and medium-sized businesses. This development was pos-
sible only where appropriate safeguards could be established
against borrower default, thus calling for the use of specialized
lending techniques. In the institutional structure of the business
credit market it brought about closer competitive relations mainly
between banks and commercial finance companies.
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