Mercantile Credit, Monetary Policy, and Size of Firms

IN the continuing debate about the role of money, credit, and monetary policy in our society, one of the major issues centers around the specific incidence of "tight money" on individual business firms. On the one hand, leading proponents of monetary controls as a regulatory device have emphasized the general, impersonal nature of such controls. They have argued that the impact of monetary policy is determined by the reaction of individual borrowers to changed market conditions. On the other hand, critics of general controls have suggested that institutional changes have led to discrimination by suppliers in the market for money and credit. Differences in size of firm, market structure, or type of industry, the amount of liquid assets which firms may accumulate, imperfections in the capital markets, and a variety of other institutional phenomena have been offered as reasons for the failure of monetary policy to operate as a general, impersonal, control device. Some of these institutional restrictions have been summarized under the general heading of "credit rationing. " Both conjecture and empirical observation of the structure of bank loans have suggested that credit rationing favors large firms. ' But those who suggest that this is the case ignore important institutional arrangements that work in the opposite direction. Banks and financial institutions are not the only sources of credit for small firms. The existence of a large volume of interfirm (mercantile) credit makes it apparent that business firms borrow from each other.2 Variations in the volume and distribution of mercantile credit are important accompaniments of monetary policy changes. During the recent tight money period, for example, the increase in mercantile credit by the manufacturing sector was three times larger than the increase in the money supply (currency plus adjusted demand deposits). We show below that, when money was tightened, firms with relatively large cash balances increased the average length of time for which credit was extended. And this extension of trade credit appears to have favored these firms against whom credit rationing is said to discriminate. Hence the credit provided by banks and financial institutions seems to have been redistributed to restore much of the general, impersonal nature of monetary controls during I955-57. Moreover, the reduction in cash balances by liquid firms helps to explain the increase in the income velocity of money during the recent tight money period. The following section examines the relationship between a measure of monetary tightness and the liquidity of manufacturing firms of varying size. Section II discusses the important factors influencing the allocation of trade credit. Section III points out differences in the sources and allocation of funds for large and small firms during I955-57 and compares the impor* I appreciate the assistance and helpful suggestions of my colleagues G. L. Bach, R. M. Cyert, David Granick, and Edwin Mansfield, who read earlier drafts of this paper. This research was supported by grants of the Carnegie Institute of Technology Graduate School of Industrial Administration from the School's research funds and from funds provided by the Ford Foundation for the study of organizational behavior. 'Professor W. L. Smith has suggested that small firms ''are more dependent on the banking system than large firms are, have fewer alternative sources of funds, and seem in general to be more vulnerable to the effects of tight credit. " Compendium of Papers Submitted by Panelists Before the Joint Economic Committee, March 3I, I958, 505-506. Over a year earlier, the Committee had summarized the situation as follows: Chairman Patman: "It is the little fellow that is hurt, and the big fellow is not hurt at all. " "Monetary Policy: I955-56," Hearing before the Subcommittee on Economic Stabilization of the Joint Economic Committee, December io and ii, I956, 34-35. See also J. K. Galbraith, "Market Structure and Stabilization Policy," this REVIEW, XXXIX (May I957), I24-33. 2 Lending by suppliers to their customers through the extension of trade credit has long been recognized as a form of interfirm relationship. Sayers and Foulke have noted that one of the prime reasons for the development of mercantile credit in the nineteenth century was the need of merchants to obtain short-term credits in circumstances under which banks did not lend. R. S. Sayers, "Central Banking in the Light of Recent British and American Experience," Quarterly Journal of Economics, Lxiii (May I949); R. Foulke, Behind the Scenes of Business, Dun and Bradstreet, I937.