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Telling
apart a bill of exchange and a mortgage
Charles Rist writes in his History of Money and Credit from
John Law to the Present Day that “identifying the discount rate
with the rate of interest, which is frequent among English writers, is an
unfortunate source of confusion”. One English writer who is free from
that blemish is John Fullarton. In the great debate
between the Banking School which he represented, and the Currency School
which he opposed, he wrote in 1844:
“It is a great error indeed to imagine that the demand
for…a loan of capital is identical with the demand for additional means
of circulation, or even that the two are frequently
associated. Each demand originates in circumstances peculiarly affecting
itself, and very distinct from the other.”
The confusion
of which Rist talks about is the thinking that
“discount rate” is just another name for short-term rate of
interest, and the difference between the two does not go beyond the
difference in the manner collecting it, either by charging it at the end of
the loan period, or taking it out from the proceeds of the loan in advance.
As a matter of fact, the difference goes far deeper than that. The two rates
are entirely different conceptually. Their sources are different. Forces
formatting them are different.
There are two
sources of credit, with a continental divide between them. To recognize this
fact is especially important for the banker’s profession. As the old
aphorism says, there is no easier profession than that of a banker, as long
as he can tell apart a bill of exchange and a mortgage.
Fixed versus
circulating capital
According to
Adam Smith “there are two different ways in which capital may be
employed so as to yield a revenue…to its
employer…: circulating capital… and fixed capital.” As a
first approximation may we just say that one source of credit has to do with fixed
capital and its scarcity is measured by the rate of interest, while the
other has to do with circulating capital and its scarcity is measured
by the discount rate. Both rates are a market
phenomenon: the former is regulated by the bond market, and the latter by the bill
market. The rate of interest varies inversely with the propensity to
save, and the discount rate varies inversely with the propensity to
consume. A common mistake is to assume that the two propensities are
antithetical, that is, when people save more they must consume less, and vice
versa. This simplistic view ignores the propensity to hoard. In
monetary economics hoarding is not a subset of saving. Hoarding is more like
the opposite of saving: it originates in protest against low interest rates.
I shall not go into the problem of hoarding here which is a topic for another
occasion. Suffice it to say that it is possible for both the propensity to
save and the propensity to consume to fall at the same time. The paradox
finds its explanation in the simultaneous rise in the propensity to hoard.
Social Circulating Capital
Recall
Adam Smith’s concept of social circulating capital from The
Wealth of Nations. It is that mass of finished goods demanded most
urgently by the consumer, plus the mass of semi-finished goods that go into
their production. Social circulating capital must move through the various
stages of production and distribution sufficiently fast so that the
end-product will have been sold to the ultimate cash-paying consumer in less
than 91 days (or 13 weeks, or 3 months: the length of the seasons of the
year).
Social
circulating capital does change both as to its volume and its composition. The
latter follows the change of seasons. Volume changes with the propensity to
consume: it expands or contracts according as the propensity gets higher or
lower. The criterion to decide whether an item does or doesn’t belong
to the social circulating capital is whether the bill of exchange on that
item will or will not circulate spontaneously.
Marginal
productivity of circulating capital
Every
finished good belonging to the social circulating capital has its own rate of
productivity measured by the ratio between the percentage or retail mark-up
and the average length of sojourn of that item on the shelf of the
shopkeeper. For example, if the markup on $1 worth of sauerkraut is ½
cent, and the average length of sojourn of a bottle of sauerkraut on the shelf
is 3 months, then the productivity of sauerkraut is 1312/2126 == percent per
annum. The item with the lowest productivity on the shelf of the marginal
shopkeeper is called the marginal item of social circulating capital.
It is the item that will first disappear from the shelf if the propensity to
consume declines, as it will not be reordered. Another item on the shelf with
a higher productivity will take its place as the marginal item. The marginal
shopkeeper is the first among the shopkeepers to change the composition
of his stock on display following a change in the propensity to consume.
The rate of marginal productivity of social circulating capital is
that rate at which the opportunity cost of carrying the marginal item on the
shelf becomes critical to the marginal shopkeeper. The reference is to his
opportunity to carry bills drawn on other shopkeepers handling faster-moving
merchandise, rather than carrying the marginal item on his shelf. Indeed, the
marginal shopkeeper is the arbitrageur who lets his stock of marginal
merchandise get sold out without replenishing it, and who buys bills with the
proceeds whenever the propensity to consume declines. Conversely, the
marginal shopkeeper will sell bills from portfolio and reorder some
heretofore submarginal items which he is willing to
display on the shelf once the propensity to consume increases. This arbitrage
enables him to eliminate variations in his income due to seasonal and other
changes in demand. At the same time he can, thanks to his bill portfolio,
participate in the earnings of other shopkeepers operating with higher
productivity.
Marginal
productivity of fixed capital
My
readers will recognize the obvious analogy between the arbitrage of the marginal
entrepreneur trading bonds against capital goods deployed in production, and
that of the marginal shopkeeper trading bills against consumer goods
displayed on his shelf. In my earlier paper The Paradox of Interest
Revisited I have described the ceiling of the rate of interest as the
rate of marginal productivity of fixed capital. It is the rate at which the
opportunity cost of carrying capital stock becomes critical to the marginal
entrepreneur. The
next increase in the
rate of interest will prompt him to sell his capital stock ― in view of
his opportunity to carry his capital assets in the form of the
higher-yielding bond. Thus the rate of interest is regulated by the arbitrage
operations of entrepreneurs between the bond market and the market for
capital goods. They will not let the rate of interest go through the ceiling.
They will stop production, discontinue maintenance of capital stock, abolish
depreciation quotas, and with the savings they will keep buying the
undervalued bond whenever the rate of interest is too high (the price of bond
is too low). They will refrain from buying new capital equipment and refuse
to expand production until bond prices recover. At that time they sell their
bonds at a profit, re-equip their factories, and join productive enterprise
once more. We see that persistent buying of bonds by entrepreneurs will cap
the rate of interest at the ceiling. We also see that the marginal
entrepreneur can, thanks to his bond portfolio, participate in the earnings
of other entrepreneurs operating with higher productivity. This is just the
well-known interest-rate cycle demonstrating the damping effect of high
interest rates, and the stimulating effect of low interest rates, on
production.
A
symbiosis
Changes
in the marginal productivity of social circulating capital reflect changes in
the propensity to consume. But they also help financing the stockpiling of
seasonal merchandise. For example, winter is the season for selling vast
quantities of fuel in the temperate zones. Come spring, merchants sell out
their inventory of fuel without replenishing stocks. They invest their funds
in the bills of other merchants who are just entering their main season, say,
those who sell gardening equipment and flower seeds. It is this symbiosis
that makes the shopkeeper’s job possible in the face of the seasonal
nature of the business, and in the face of the proverbial capriciousness of
consumers. When in their main season the shopkeepers’ income is
generated by selling merchandise in high demand. When in their slow season,
their income is augmented by the discount earned while holding bills drawn on
merchants in their high season. At the same time they help their colleagues
finance stockpiles.
It is important to realize that social circulating capital constantly
changes its constitution as various items of consumer goods fall in and out
of it, due to changes of the seasons of the year, or to changes in the
propensity to consume. Classical economics maintains that it is the price
mechanism that brings about equilibrium between the supply and demand of
consumer goods. The fact, however, is that the price mechanism is too
sluggish and cannot keep up with the capriciousness of the propensity to
consume. The supply/demand equilibrium theory of price also fails to explain
why the cost of fuel in winter does not go sky high. In fact, it is not
significantly higher than in summer.
Second
source of credit
In
other words, we are looking for an explanation how the market for consumer
goods deals with the problem of seasonality of merchandise and capriciousness
of consumer demand. The explanation can be found in the nimbleness of the
discount rate, and the fact that bills of exchange drawn on goods moving fast
enough to the ultimate cash-paying consumer enter monetary circulation
spontaneously. As semi-finished goods keep “maturing”, and as
producers pass them along, one to the next, they accept bills of exchange in
payment. This epitomizes a second source of credit namely clearing. It
is in addition to the first which is saving. The maturing consumer
good is in sufficient proximity to the ultimate cash-paying consumer so that
its removal from the market can hardly be doubted. The usual risks associated
with production disappear. At that point the market “monetizes”
the bill lending it ephemeral monetary qualities.
Credit independent of lending and borrowing
Indeed,
credit can and does arise independently of lending and borrowing. Take the
example of wool and its journey from the sheep-farm to the cloth store,
involving the sheep-farmer, the wool merchant, the spinner, the weaver, and
the cloth merchant. When the weaver draws a bill on the cloth merchant
calling for payment in 91 days, he is certainly extending credit. Yet in
spite of appearances the weaver is not a lender and the cloth merchant is not
a borrower, and it would be wrong to look at the transaction as a
loan. The perception that the drawer of a bill grants a loan to the acceptor which
the latter repays at maturity is entirely fallacious and must be resisted. It
is preposterous to suggest that the producer of higher-order goods is lending
when he supplies semi-finished goods to the producer of lower-order goods. The
semi-finished good hardly has a marketability,
although it will improve greatly in the hands of the producer of the
lower-order good. It is always the producer of the lower-order good, by
virtue of standing that much closer to the ultimate cash-paying consumer, who
is instrumental in the rise of this type of credit arising, as it is, from
clearing rather than from lending. The credit is an integral part of the deal
to supply producers of lower-order goods with semi-finished products by
producers of higher-order goods. By merchant custom the term “91 days
net” is part of every such commercial deal. Stated otherwise, prices
quoted by the wholesaler to the retailer are discountable prices. The amount
of discount depends on the number of days the credit is being used, and on the
discount rate prevailing at the time of the commercial transaction.
“Wagon-way
in the air”
The
bill drawn on the cloth merchant by the weaver, properly endorsed, is
acceptable in payment by the spinner for the yarn. The same bill is further
acceptable in payment by the wool merchant for the wool delivered. (Accepting
a bill in payment is also called “discounting” it, since the face
value is discounted by the number of days remaining to maturity.) In fact the
demand for bills is such that they are acceptable even outside of the nexus
of the wool and cloth trade. Producers of higher-order goods will accept them
when delivering semi-finished products to their customers. With two good
signatures and a string of subsequent endorsements on the back, the bill is a
potent form of means of exchange. In a “violent metaphor” which
looked so outrageous in 1776 that Adam Smith thought he ought to apologize
for its use in the Wealth of Nations, the bill of exchange is a
“wagon-way in the air” freeing up valuable land for growing
produce. The meaning is that the use of bills as a circulating medium frees
up funds and makes them available for use as fixed capital.
Achillean heel of
monetarism
The
foregoing illustrates the contact between interest and the marginal
productivity of fixed capital, and the analogous contact between discount and
the marginal productivity of circulating capital. The latter is embodied by
the marvelous instrument that emerged in the trading Italian city-states of
the Trecento, the bill of exchange.
The idea that the bill of exchange can circulate on its own wings and
under its own steam has been ridiculed by devotees of the Quantity Theory of
Money. The vicious attacks on the Real Bills Doctrine expose the Achillean heel of monetarism. It reveals that an increase
in the quantity of purchasing media will not always and necessarily cause a
rise in prices. If the new purchasing media emerges simultaneously with the
new merchandise, and the two disappear together as the merchandise is removed
from the market by the ultimate cash-paying consumer (as is the case whenever
the production and distribution of consumer goods
is
financed through bills of exchange), there will be no price rises on
account of an increase in the volume of bill circulation.
The
most liquid earning asset in existence
After
discounting bills has become a universal practice, demand for them increased
greatly. Tradesmen found it to their advantage to hold the bills drawn on
retail merchants to maturity. They looked at bills as a unique instrument
combining two seemingly contradictory features, that of being (1) an earning
asset, and (2) a medium of exchange. In fact, bills provided the only way of
generating an income on cash holdings temporarily idled by seasonal factors
or by an unexpected fall in the propensity to consume. As a rule, earning
assets are illiquid. It takes time to liquidate them, to say nothing of
possible losses. With the appearance of discounting all this has changed. Now
tradesmen could earn an income on that part of their circulating capital
which they had to carry in the form of cash temporarily. As most businesses
are cyclical in nature, tradesmen have faced great fluctuations in their cash
needs. Now they can enjoy an income generated on their idled circulating
capital as they are entering their slow season. The bill of exchange is
the most liquid earning asset in existence.
Theorem
on the Formation of the Discount Rate
The
discount rate is equal to the rate of marginal productivity of social
circulating capital. Indeed, if the discount rate rises,
the marginal shopkeeper no longer finds it profitable to carry the marginal
item on his shelf and will discontinue it. Social circulating capital shrinks
and another item with a higher productivity will take over as the marginal
item. The rate of marginal productivity of social circulating capital
therefore increases along with the discount rate. Conversely, if the discount
rate falls, the marginal shopkeeper can afford to display hitherto submarginal items on his shelves. Social circulating
capital expands as the marginal item is replaced by another item with a lower
productivity. We conclude that the rate of marginal productivity falls
together with the discount rate.
Shopkeepers
will not let the discount rate deviate from the rate of marginal productivity
of social circulating capital. Such a deviation would offer profitable
risk-free arbitrage opportunities. If the discount rate exceeded the rate of
marginal productivity, then shopkeepers would sell out marginal merchandise
and put the proceeds into bills. In the opposite case, when the rate of
marginal productivity exceeded the discount rate, shopkeepers would sell
bills from portfolio and use the proceeds to display more marginal
merchandise on their shelves. In either case the spread between the two rates
would close and the opportunity for risk free profits would disappear. It is
clear that the discount rate is regulated by the shopkeepers who follow
orders issued by the sovereign consumer.
Real
Bills Doctrine
The
market economy comes equipped with a natural built-in clearing system that
will generate all the credit necessary to move goods in high demand from the
producers to the retail outlets. These credits do not originate in savings.
They originate in clearing. They originate in the very process whereby
producers of higher-order goods pass along the maturing semi-finished good to
producers of lower-order goods.
A
real bill is a bill of exchange drawn by the wholesale merchant (the drawer
of the bill) on the retail merchant (the acceptor of the bill) specifying the
kind, quality and quantity of merchandise shipped, and specifying the sum
(the face value of the bill) and the date on which it falls due (the maturity
date of the bill, in any event no longer than 91 days from the
date of billing). In
order to be valid, the bill has to be accepted by the retail merchant writing
across its face over his signature “I accept”.
The
Real Bills Doctrine of Adam Smith states that a real bill can, before its
maturity date, circulate as a purchasing medium. Specifically, the wholesale
merchant can use the bill he has drawn on the retail merchant to pay his suppliers
by endorsing the bill on the back. Everyone who subsequently receives the
bill in payment can use it in a similar fashion. Endorsement signifies that
one endorser has assigned the proceeds to the next. Upon maturity bearer will
mark the bill “paid” over his signature, and will turn it over to
the retail merchant against payment of face value.
The
real bill is a non-inflationary purchasing medium which the market has
endowed with limited monetary privileges. Non-inflationary, because the
face value of the bill is matched dollar-for-dollar by the value of the
emerging merchandise. Limited, because upon maturity the purchasing medium
expires while the underlying merchandise is removed from the market by the
ultimate cash-paying consumer.
In
many ways the spontaneous circulation of real bills is a miraculous process.
Nobody has designed this system of clearing that makes goods in demand move
along from the producer to the consumer without outside financing. Emerging
goods finance their own production and distribution without taking one penny
out of the piggy-banks of savers, and without legal-tender coercion, as long
as they are demanded urgently enough by the consumer.
Self-liquidating
credit
For
this reason the real bill is said to represent self-liquidating credit.
The ultimate sale of the underlying merchandise will liquidate all the
credits that have been granted in moving it forward to the consumer, whether
there are four, fourteen, or forty hands involved in the process. Progress in
division of labor, making the journey of goods from producers to consumers
ever more “roundabout”, will never cause a shortage of purchasing
media (as it would under the so-called 100% gold standard).
Gold
Standard
Under
the international gold standard there arises a tendency for gold to flow from
a country with a lower discount rate to another with a higher one. As a
result the discount rate tends to get equalized in all those countries
adhering to the gold standard. The gold flows are induced by arbitrage in
bills drawn on various foreign centers. Continuing arbitrage would keep up
the gold flows until the spread between the various discount rates
disappeared. This observation invites the following critique of the classical
theory of the international gold standard (due to Cantillon),
according to which gold flows across international boundaries induce changes
in the relative price levels between countries ― purporting to explain
the adjustment mechanism of international trade by claiming that the price
level is supposed to rise or fall according as the country is gaining or
losing gold.
In
reality this is not what happens. As our more sophisticated model shows, if
the country gains gold, the new gold will first flow to the bill market and bid
up the price of bills. The greater relative abundance of gold will lower the
discount rate. In response shopkeepers will fill their empty shelf-space with
marginal merchandise. The gold inflow will not pump up the price level. By
the time the new gold trickles down to the rest of the economy in the form of
higher wages and profits, the extra merchandise will be in place waiting for
the greater consumer spending to materialize. Conversely, if the country
loses gold, the gold is withdrawn from the bill market. There is an immediate
increase in the discount rate, causing
shopkeepers
to eliminate marginal merchandise from the shelves. The gold outflow or
increased gold hoarding will not result in a squeeze on prices. Instead, it
will cause social circulating capital to contract. Marginal merchandise will
no longer be available in every grocery store. The consumer who still wants
it will have to search for it in specialty shops, or order it directly from
the producer.
International
gold flows
Economists
are still wondering how the Bank of England could run the international gold
standard on such a paltry gold reserve during the one-hundred-year period
between the Napoleonic Wars and World War One, and how the enormous volume of
pre-1914 world trade could be financed with such meager gold flows as
recorded by statisticians.
The
explanation is that it is not the difference in relative prices but the
difference in the discount rates that is the real driving force of world
trade. You couldn’t do better than exporting to a country with the
highest discount rate. This particular profit opportunity is ephemeral and
will disappear momentarily due to competition. Imports are financed by
exports, not by gold flows. Even capital movements from one country to another
are financed by trade flows under the gold standard. Just as the discount
rate, the rate of interest also tends to get equalized among countries that
adhere to the gold standard. Capital flows piggyback
trade flows. The capital-importing country has, of necessity, a higher
discount rate that will not fall until after the capital import has been
completed. Gold flows hardly ever cross international boundaries.
It
is hard for the contemporary observer to fathom just how efficient the
international gold standard had been, thanks entirely to the spontaneous
monetization of real bills, before the Guns of August shot it to pieces in
1914.
Fundamental
Principle of the Retail Trade
The
adjustment mechanism which brings into balance the amount of gold in
circulation with the supply of goods in retail trade does not operate on the
price level, as wrongly suggested by the Quantity Theory of Money. It
operates on the marginal productivity of social circulating capital or, what
is the same, on the discount rate. In
particular, the law of supply and demand is not applicable to the retail
trade. An autonomous increase in demand for consumer goods has no inevitable
effect on prices but will, instead, lower the discount rate. This is
synonymous with an increase in the volume of social circulating capital.
Under the gold standard increased demand automatically brings out an
equivalent increase in supply. An autonomous decrease in demand has the
opposite effect. There is no such a thing as an autonomous change in supply
as far as the retail trade is concerned: supply is strictly regulated by
demand through the mechanism of the bill market and the discount rate.
Failure
of the Quantity Theory
If
a country is stricken with an earthquake or some other calamity destroying
property and goods, there will be an immediate increase in the discount rate.
Retail prices will not rise inevitably if the country is on the international
gold standard. The stricken country, thanks to its higher discount rate, is
an attractive place on which to draw bills. This translates into an immediate
influx of short-term capital from abroad in the form of the most urgently
needed consumer goods.
If
the output of gold mines in a country increases by leaps and bounds, or if
there is an invasion of foreign gold, there will be no inevitable increase in
retail prices as predicted by
the vulgar theory of
the gold standard. The discount rate will drop at once, and merchants will
start drawing bills on foreign countries with a higher discount rate, thus
repelling the invasion of foreign gold and expelling the excess of domestic
gold. If they run out of shelf-space, shopkeepers will use the sidewalk. At
any rate, the spin-off from higher incomes due to the greater availability of
gold will be met by a commensurate expansion of the offering of marginal
merchandise which shopkeepers are able to display, thanks to the lower
marginal productivity of social circulating capital. The greater availability
of gold will, in this case as in every other, call out an appropriate
increase in the supply of marginal merchandise. Retail price rises are always
and everywhere the result of the scarcity of goods, and never a greater
availability of gold.
The Quantity Theory
of Money as it is applied to the retail trade under a gold standard is false.
Antal E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
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DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE
AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
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Copyright © 2002-2008 by Antal
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