We are on a roller-coaster ride plunging the world into zero-velocity of money and into barter
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
–> 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 this third part,
we look at how credit comes into existence (via arbitrage, of course) with
legitimate entrepreneur borrowers. We also look at the counterfeit credit of
the central banks (which is not arbitrage). We introduce the concept of speculation in markets for government promises,
compared to legitimate trading of commodities. We also discuss the prerequisite
concepts. Marginal time preference and marginal productivity are absolutely essential to
the theory of interest and prices. That leads to the last new concept resonance.
In the gold
standard, credit comes into existence when one party lends and another borrows.
The lender is a saver who prefers earning interest to hoarding his gold. The
borrower is an arbitrager who sees an opportunity to earn a net profit greater
than the rate of interest.
As with all markets,
there is a bid and an offer (also called the “ask”) in the bond market. The bid
and the offer are placed by the saver and the entrepreneur, respectively. The
saver prefers a higher rate of interest, which means a lower bond price (price
and interest rate vary inversely). The entrepreneur prefers a lower rate and a
higher bond price.
Increased savings
tends to cause the interest rate to fall, whereas increased entrepreneurial
activity tends to cause a rise. These are not symmetrical, however. If savings
fall, then the interest rate must go up. The
mechanism that denies credit to the marginal entrepreneur is the lower bond
price. But, if savings rise, interest does not necessarily go
down much. Entrepreneurs can issue more bonds. Savings is always finite, but
the potential supply of bonds is unlimited.
What is the bond
seller—the entrepreneur—doing with the money raised by selling the bond? He is
buying real estate, buildings, plant, equipment, trucks, etc. He is producing
something that will make a profit that, net of all costs, is greater than the
interest he must pay. He is doing arbitrage between
the rate of interest and the rate of profit.
It may seem an odd
way to think of it, but consider the entrepreneur to be long the interest rate
and short the profit rate. Looking from this perspective will help illustrate
the principle that arbitrage always has the effect of compressing the spread.
The arbitrager lifts the offer on his long leg and presses the bid on his short
leg. The entrepreneur is elevating the rate of interest and depressing the rate
of profit.
Now let’s move our
focus to the Fed and its irredeemable dollar. The Fed exists to enable the
government and favored cronies to borrow more, at lower interest, and without
responsibility to extinguish their debts.
People often use the
shorthand of saying that the Fed “prints” dollars. It is more accurate to say that
it borrows them into existence, though there is no (knowing) lender. The Fed
has the sole discretion to create these dollars ex nihilo, unlike a normal bank
that must persuade a saver to deposit them. By this reason alone, the Fed’s
credit is counterfeit. The very purpose of the Fed is to cause inflation, which I define as an expansion of
counterfeit credit[1].
These borrowed
dollars are the Fed’s liability. It uses them to buy assets such as bonds or to
otherwise lend. Those bonds or loans are its assets. While the Fed can create
its own funding, its own liabilities, it still must heed its balance sheet. If
the value of its assets ever falls too far, the market will not accept its
liability. Gold owners will refuse to bid on the dollar. Through a process of
arbitrage (of course), the dollar will collapse.[2]
What does the
government get from this game? It diverts resources away from value-creating
activities into the government’s welfare programs, graft, regulatory agencies,
and vast bureaucracy. By suppressing interest rates and enabling debts to be
perpetually rolled, the Fed enables the government to consume much more than it
could in a free market. Politicians are enabled to buy votes without raising
taxes.
Earlier, I said
there is no knowing lender. Let’s look at
this mysterious unknowing lender. He is industrious and frugal, consuming less
than he produces, keeping the difference as savings. He feeds this savings, the
product of his hard work, into the government’s hungry maw. Unfortunately, the
credit he extends is irredeemable. The paper promise he accepts has a warning
written in fine print: it will never be honored. The lender is a
self-sacrificial chump. Who is he?
He is anyone who has
demand for dollars.
He is the trader who
thinks that gold is “going up” (in terms of dollars). He is the businessman who
uses the dollar as the unit of account on his income statement. He is the
investor who measures his gains or losses in dollars. He is every enabler who
does not distinguish between the dollar and money.
People don’t think
of their savings in this light, that they are freely offering it to the
government to consume. They don’t understand that savings is impossible using
counterfeit credit.
Now we have covered
the counterfeit credit of th Fed, let’s move on to cover another prerequisite
topic: speculation. With arbitrage, I offered
in Part II a much broader definition than the one commonly used. With speculation, I will now present a narrower concept than
the usual definition. Let’s build up to it by looking at some examples.
The first example is
the case of agricultural commodities, such as wheat. Production is subject to
unpredictable conditions imposed by nature, like weather. If early rain reduces
the wheat yield by 5%, then there could be a shortage. Think of the
dislocations that would occur if the price of wheat remained low. Inventories
from the prior crop would be consumed too rapidly at the old price. Then, when
the reduced new crop was harvested, it would be too late for a small reduction
in consumption. Grain consumers would suffer undue hardship.
Futures traders
perform a valuable economic function. Their profit comes from helping to drive
prices up (in this example) as soon as possible, and thus discourage
consumption, encourage more production, and attract wheat to be shipped in from
unaffected regions. Good traders study and anticipate nature-made risks to
valuable goods and earn their profits by providing price signals to producers
and consumers.
Trading commodities
futures is a legitimate activity that helps people coordinate their activities.
If such traders were removed, the result would be reduced coordination (i.e.
waste). Therefore my definition of speculation excludes
commodities traders.
There are two
elephants in the room of the irredeemable currency regime: interest and foreign
exchange rates. It is the profiteer in these games who earns the dubious label
of speculator.
The price of each
currency is constantly changing in terms of all others. To any business that
operates across borders, this creates unbearable risk. They are forced to
hedge. The banks that provide such hedging products must, themselves, hedge.
One result is volatile currency markets.
The rate of interest
presents the other big man-made risk. Unlike in gold, interest in irredeemable
paper is always changing and is often quite volatile. For example, the interest
rate on the 10-year Treasury bond has gone from 1.63% to 2.16% just during the
month of May. As with currencies, there is a big need to hedge this risk, and
hence, a massive derivatives market.
Naturally,
volatility attracts traders, in this case the speculators. Their
gains are not profits from anticipating natural risks to the production of real
commodities. They are not skilled in responding to nature. They are front-runners of the artificial risks created by
the next move of the government or central bank. Worse still, they seek to influence the government and central bank to act
favorably to their interests.
Unlike the trader in
commodities, the speculator in man-made irredeemable
promises is a parasite. This is not a judgment of any particular speculator,
but rather an indictment of the entire dollar regime. It imposes risks, losses,
and costs on productive businesses, while transferring enormous gains to speculators.
It is no coincidence
that the financial sector (and the derivatives market) has grown as the
productive sector has been shrinking. A good analogy is to call it a cancer
that consumes the economic body, by feeding on its capital. A free market does
not offer gains to those who add no value, much less to parasites who consume
value and destroy wealth. The rise of thespeculator is
due entirely to the perverse incentives created by coercive government
interference.[3]
In light of the
context we’ve established, we are now ready to start looking at interest rates.
In the gold standard, the mechanism is fairly simple as I wrote in “The
Unadulterated Gold Standard Part III (Features)”:
This trade-off
between hoarding the gold coin and depositing it in the bank sets the floor
under the rate of interest. Every depositor has his threshold. If
the rate falls (or credit risk rises) sufficiently, and enough depositors at
the margin withdraw their gold, then the banking system is deprived of
deposits, which drives down the price of the bond which forces the rate of
interest up. This is one half of the mechanism that acts to keep the rate
of interest stable.
The ceiling above
the interest rate is set by the marginal business. No business can borrow
at a rate higher than its rate of profit. If the rate ticks above this,
the marginal business is the first to buy back its outstanding bonds and sell
capital stock (or at least not sell a bond to expand). Ultimately, the
marginal businessman may liquidate and put his money into the bonds of a more
productive enterprise.[4]
To state this in
more abstract and precise terms, the rate of interest in the gold standard is
always in a narrow range between marginal time preference and marginal productivity.[5]
The phenomena of
time preference and productivity do not go away when there are legal tender
laws. The government attempts to disenfranchise savers,
to remove their influence over the rate of interest and their power to contract
banking system credit.
In the gold
standard, when one redeems a bank deposit or sells a bond, one takes home gold
coins. This pushes up the rate of interest and forces a contraction of banking
system credit. The reason to do this is because one does not like the rate of
interest, or one is uncomfortable with the risk. It goes almost without saying
that holding one’s savings in gold coins is preferable to lending with
insufficient interest or excessive risk.
By contrast, in
irredeemable currency, there is no real choice. A dollar bill is a zero yield
credit. If one is forced to take the credit risk, then one might as well get
some interest. Unlike gold, there is little reason to hoard dollar bills.
The central planners
may impose their will on the market; it is within their power to distort the
bond market. But they cannot repeal the law of gravity, increase the speed of
light, or alter the nature of man. The laws of economics operate even under bad
legislative law. There are horrible consequences to pushing the rate of
interest below the marginal time preference,
which we will study later in this series. The saver is not entirely
disenfranchised. He can’t avoid harm, but his attempt to protect himself sets
quite a dynamic in motion.
It should also be
mentioned that speculators affect and are
affected by the market for government credit. Their behavior is not random, nor
scattered. Speculators often act as a herd, not being driven by arbitrage but
by government policy. They anticipate and respond to volatility. They can often
race from one side of a trade to the other, en masse. This is a good segue to
our final prerequisite concept.
The linear Quantity
Theory of Money tempts us to think that when the Fed pumps more dollars into
the economy, this must cause prices to rise. If there were an analogous linear
theory of airplane flight, it would predict that pulling back on the yoke under
any circumstance would cause the plane to climb. Good pilots know that if the
plane is descending in a spiral, pulling back will tighten the spiral. Many an
inexperienced pilot has crashed from making this error.
The Fed adds another
confounding factor: its pumping is not steady but pulsed. Both in the short-
and the long-term, their dollar creation is not steady and smooth. Short term,
they buy bonds on some days but not others. Long term, they sometimes pause to
assess the results; they know there are leads and lags. They also provide
verbal and non-verbal signals to attempt to influence the markets.
In a mechanical or
electrical system, a periodic input of energy can cause oscillation. Antal
Fekete first proposed that oscillation occurs in the monetary system. Here, he
compares it to the collapse of an infamous bridge:
It is hyperdeflation
[currently]. The Fed is desperately trying to fight it, but all is in vain. We
are on a roller-coaster ride plunging the world into zero-velocity of money and
into barter. In my lectures at the New Austrian School of Economics I often
point out the similarity with the collapse of the Tacoma Bridge in 1941.[6]
I will end with a
few questions. What happens if the central bank pushes the rate of interest
below the marginal time preference? Could this set in motion a non-linear
oscillation? If so, will this oscillation be damped via negative feedback akin
to friction? Or will periodic inputs of credit inject positive feedback into
the system, causing resonance?
In Part IV, we will answer these questions and, at last, dive in to the
theory of prices and interest rates.
[3] See my
dissertation for an extensive discussion of government interference: A Free Market for
Goods, Services, and Money
[5] Interested
readers are referred to the subsite on Professor Antal
Fekete’s website where he presents his theory of interest and capital markets.
[6] Antal Fekete: Gold
Backwardation and the Collapse of the Tacoma Bridge with Anthony Wile
This entry was posted in Monetary Science on June
16, 2013.
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