What happens if the central bank pushes the rate of interest below the marginal time preference?
by Keith Weiner
In Part I, we looked at the concepts of
nonlinearity, dynamics, multivariate, state, and contiguity. We showed that
whatever the relationship may be between prices and the money supply in
irredeemable paper currency, it is not a simple matter of rising money supply à
rising prices.
In Part II, we discussed the mechanics
of the formation of the bid price and ask price, the concepts of stocks and
flows, and the central concept of arbitrage. We showed how arbitrage is the key
to the money supply in the gold standard; miners add to the aboveground stocks
of gold when the cost of producing an ounce of gold is less than the value of
one ounce.
In PartIII, we looked at how credit comes into existence via arbitrage with
legitimate entrepreneur borrowers. We also looked at the counterfeit credit of
the central banks, which is not arbitrage. We introduced the concept of speculation in markets for government promises,
compared to legitimate trading of commodities. We also discussed the
prerequisite concepts of Marginal time preference and marginal productivity, and resonance.
Part III ended with a
question:
“What happens if the central bank pushes the rate of interest below the marginal time preference?”
To my knowledge, Antal Fekete
was the first to ask this question[1]. It is now time to explore the answer.
We are dealing with a cycle.
It is not a simple or linear relationship between quantity X and quantity Y,
much to the frustration of students of economics (and central planners).
The cycle begins when the
central bank pushes the rate of interest down, below the rate of marginal time
preference. Unlike in the gold standard, under a paper currency, the disenfranchised
savers cannot turn to gold. Perhaps it has been made illegal as it was in the
U.S. from 1933 to 1975. Or it could merely be taxed and creditors placed under
duress to accept repayment in irredeemable paper. Whatever the reason, the
saver cannot perform arbitrage between the gold coin and the bond[2], as he
could in the gold standard. He is trapped. The irredeemable paper currency is a
closed loop system. The saver is not entirely without options, however.
He can buy commodities or
finished goods.
I can distinctly recall as a
boy in the late 1970’s, when my parents would buy cans of tuna fish, they would
buy 50 or 100 cans (we ate tuna on Sunday, two cans). Prices were rising very
rapidly, and so it made sense to them to hold capital in the form of food
stocks rather than dollars. Indeed, prices rose so frequently that grocery
stores were going to the expense of manually applying new price stickers on top
of the old ones on inventory on the shelves. This is extraordinary, because
grocers sell through inventory quickly. Some benighted people began agitating
for a law to prohibit this practice (perhaps descendants of King Canute,
reputed to have ordered the tide to recede?).
Consumers are not the only
ones to play the game, and they don’t have a direct impact on the rate of
interest. Corporations also play. When the rate of interest is below the rate
of marginal time preference, we know that it is also below the rate of marginal
productivity. Corporations can sell bonds in order to buy commodities. They can
also accumulate inventory buffers of each input, partially completed items at
each state of production, and finished products.
What happens if corporations
are selling bonds in order to expand holdings of commodities and goods made
from commodities? If this trade occurs at large enough scale, it will push up the rate of interest as well as prices. Let the irony
sink in. The cycle begins as an attempt to push interest rates down. The result is the opposite.
Analysts of this phenomenon
must be aware that the government or its central bank cannot change the primary
trend. They can exaggerate it and fuel it. In this case, the trend goes
opposite to their intent and there is nothing they can do about it. King Canute
could not do anything about the waves, either.
Wait. The problem was caused
when interest was pushed below time preference. Now interest has risen. Are we
out of the woods yet?
No. Unfortunately, marginal
time preference rises. Everyone can see that prices are rising rapidly, and in
such an environment, are no longer satisfied with the rate of interest that
they had previously wanted. The time preference to interest spread remains
inverted.
This is a positive feedback
loop. Prices and interest move up. And then this encourages another iteration
of the same cycle. Prices and interest move up again.
Positive feedback is very
dangerous, because it runs away very quickly. Think of holding an electric
guitar up to a loudspeaker with the amplifier turned up to 10. The slightest
sound is amplified and fed back and amplified until there is a horrible squeal.
Electrical systems contain circuits to prevent self-destruction, but alas there
is no such thing in the economy.
There are, however, other
factors that begin to come into play. The regime of irredeemable currency
forces actors in the economy to make a choice between two bad alternatives. One
option is to earn a lower rate of interest than one’s preference. Meanwhile,
prices are rising, perhaps at a rate faster than the rate of interest. Adding
insult to injury, as the interest rate rises, it imposes capital losses on
bondholders. Bonds were once called “certificates of confiscation”. There is
but one way to avoid the losses meted out to bondholders.
One can hold commodities and
inventory. There is a problem with this alternative too. The marginal utility
of commodities and inventory is rapidly falling. This means that the more one
accumulates, the lower the value of the next unit of the good. This is negative
feedback. Another problem is that it is not an efficient allocation of capital
to lock it up in illiquid inventory. Sooner or later, errors in capital
allocation accumulate to the harm of the enterprise.
There is another problem with
commodity hoarding. Unlike gold hoarding, which harms no one, hoarding of goods
that people and businesses depend on hurts people. As we shall see below,
growth in hoarding is not sustainable. What the economy needed was an increase
in the interest rate. An unstable dynamic that causes prices to rise along with
interest rates is no substitute.
The choice between losing
money in bonds, vs. buying more goods that one needs less and less, is a bitter
choice. This choice is imposed on people as an “unintended” (like all the
negative effects of central planning) consequence of the central bank’s attempt
to drive interest rates lower. I propose that this should be called Fekete’s Dilemma in the vein of the Triffin
Dilemma and Gibson’s Paradox.
Another negative feedback
factor is that rising interest rates destroy productive enterprises. Consider
the example of a company that manufactures TVs. When they built the factory,
they borrowed money at 6%. With this cost of capital, they are profitable.
Eventually, the equipment becomes worn out and/or obsolete. Black and white TVs
are no longer in demand by consumers, who want color. Making color TVs requires
new equipment. Unfortunately, at 12% interest, there is no way to make a
profit. Unable to continue making a profit on black and white, and unable to
profitably start making color, the company folds.
The more the interest rate
rises, and the longer it remains high, the more companies go bankrupt. This of
course destroys the wealth of shareholders and bondholders, and causes many
workers to be laid off. Its effect on interest rates is to pull in both
directions. When bondholders begin taking losses, bonds tend to sell off. A
falling bond price is the flip side of a rising interest rate (bond price and
yield are inverse). On the other hand, with each bankruptcy there is now one
less bidder pushing up prices. Additionally, the inventories of the bankrupt
company must be liquidated; creditors need to be paid in currency, not in
half-finished goods, or even in stockpiles of iron ingots.
A third factor is that a
rising interest rate causes a reduced burden of debt for those who have
previously borrowed at a fixed rate, such as corporations who have sold bonds.
They could buy back their own bonds, and realize a capital gain. Or, especially
if the price of their own product is rising, they have additional capacity to
borrow more to finance further expansion of their inventory buffers. This will tend to be a positive feedback.
These three phenomena are by
no means the only forces set in motion by the initial suppression of interest
rates. The take-away from this discussion should be that one must begin one’s
analysis with the individual actors in the economy, and pay attention to their
balance sheets as well as their profit and loss.
The above depiction of a
rising cycle, where rising interest rates drive rising prices, and rising
prices drive rising interest rates is not merely hypothetical. It is a picture
of what happened in the U.S. from 1947 to 1981.
Many people predicted that the
monetary system was going to collapse in the 1970’s. It may have come very
close to that point. The Tacoma Narrows Bridge swung to one side before moving
even more violently to the other. The dollar might have ended with prices and
interest rates rising faster and faster, until it was no longer accepted in
trade for goods.
But this is not what, in fact,
occurred. Things abruptly turned around. Fed Chairman Paul Volcker is now credited
with “breaking the back of inflation”. Interest rates did indeed spike up
briefly to about 16% on the 10-year Treasury in 1981. After that, they fell,
rose once more in 1984, and then settled into a falling trend (with some
volatility) that continues through today. But remember what we said above, that
a central bank can exaggerate the trend but it cannot reverse it.
Interest rates and prices had
peaked. When the marginal utility of each additional unit of accumulated goods
falls without bound, it eventually crosses the threshold of zero marginal
utility. Then it can no longer be justified. Meanwhile, bankruptcies, with
their forced liquidations, increase. A final upwards spike of interest rates
discourages any further borrowing. What company can borrow at such an extreme
interest rate and still make a profit?
At last, the time preference
to interest spread is back to normal; interest is above the time preference.
Unfortunately, there is another problem that causes the cycle to slam into
reverse. The cycle continues its dynamic of destroying wealth, confounding
central planners and economists.
The central planning fools
think that they can magically gin up some more credit-money, or extract
liquidity somehow to rectify matters. Surely, they think, they just have to
find the right money supply value. Their own theory acknowledges that there are
“leads and lags” so they work their equations to try to figure out how to get
ahead of the cycle.
A blind man would sooner hit
the bulls-eye of an archery target.
In Part V, we will examine the
mechanics of the cycle reversal, and the other side of the unstable
oscillation. Without spoiling it, let’s just say that a different dynamic
occurs which drives both interest and prices down.
[1] Fekete wrote about the
connection between interest rates and prices at least as early as 2003, in “The
Ratchet and the Linkage” and “Between Scylla and Charybdis”. He published
Monetary Economics 102: Gold and Interest (http://www.professorfekete.com/articles/AEFMonEcon102Lecture1.pdf). The idea he proposed in
those three pages has been fleshed out and extended by myself, and incorporated
into this series of papers on the theory of interest and prices, principally in
parts IV and V. I would like to note that Fekete regards the flow of money from
the bond market to the commodity market as inflation and the reverse flow as
deflation. I agree with his description of these pathologies, but prefer to
reserve the term inflation to refer to counterfeit credit. I call it the rising
cycle and falling cycle instead.
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