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- Enter: the Investment Banker ¶ The Bond
Market and the Rate of Interest ¶ The Gold Bond and Its Sinking Fund
¶ The Euthanasia of the Bondholder ¶ The Rise and Fall of the Yield-Curve ¶ Arbitrage versus
Speculation ¶ One Rate or Two? ¶ Deterioration in the Quality of
Credit ¶ Fleecing the Producers
Enter: The Investment Banker
We have arrived at the final stage, what I
figuratively call the “hexagonal model of capital markets” with
its six participants: the annuitand, the annuitant,
the entrepreneur, the inventor, the capitalist and, the last protagonist of
the drama of human action, the investment banker. His entry was made
necessary by the marginal annuitand and the
marginal annuitant. The former is the one who has just missed his chance to
form a partnership with the inventor, and the latter his, with the
entrepreneur. Without the services of the investment banker the resources
represented by the savings of the marginal annuitand
and the marginal annuitant would be lost to society.
If the two formed a partnership whereby the former
provided income for the latter, it would be net short of future wealth while
net long of present wealth. It would take the skills of a specialist to
nurture present wealth into future wealth of undiminished value. This specialist
was the investment banker. He would invest the wealth of the annuitant in
such a way that its value would grow and it could in due course be exchanged
for income to pay an annuity to the annuitand. Under
the gold standard the investment banker would buy gold bonds, the safest
paper available for the preservation of wealth.
The Bond Market and the Rate of
Interest
The hexagonal model of the capital market at last
provides a sufficiently broad basis upon which the formation of the rate of
interest can be explained. Since no two annuities and no two mortgages are
similar, trading them without a common denominator would be virtually
impossible and, as a consequence, the rate of interest would be highly
volatile. A regime of stable interest rates is not possible without the
services of the investment banker, nor without a
common denominator, the gold bond, to facilitate the trading of annuities and
mortgages.
As we shall see in the next Lecture entitled The
Bond Equation and the Rate of Interest, the price of the gold bond is
just the mirror image of the rate of interest. Although the two move in
opposite directions, either one determines the other uniquely. For this
reason we may define the rate of interest in terms of the price of the gold
bond. Thus bond trading appears as the very market process responsible for
the formation of the rate of interest. There is no market quoting the rate of
interest directly. In order to find out what the going rate of interest is
one must go to the bond market, get a quotation for the bond price, and
calculate the rate of interest from there. In dealing with the bond market we
must not forget that it is the epitome of a far larger and far more pervasive
capital market encompassing all conceivable exchanges of wealth and income. Every
such exchange, not just the purchase or sale of gold bonds, has an effect on
the formation of the rate of interest.
The investment banker’s function is clearing
and brokering. He matches the various and varied demands thrown upon the
capital market from its five corners. He must be prepared to enter into
partnership with the annuitand, the annuitant, the
entrepreneur, the inventor, and the capitalist, as the need may arise,
through his specialized instruments of mortgage and annuity contracts. At the
end of the day he balances the net liability or asset resulting from this
activity through the purchase or sale of his standardized instrument, the
gold bond. In effect, the investment banker is doing arbitrage between the
bond market and the other five corners of the capital market. The result is
the emergence of a stable rate of interest.
The hexagonal model of the capital market brings
about a great increase in scope for the most successful combination of
capitalist production: the troika of the entrepreneur, the inventor, and the
capitalist, already mentioned in the previous Lecture. From now on they can
form their partnership even if unbeknownst to one another. The inventor need
not waste time in seeking out a congenial entrepreneur, nor do the two of
them in finding a suitable capitalist. If the invention is good and the
enterprise sound, then they could start production on the most favorable terms immediately through the good offices of
the match-maker, the investment banker. He will line up a capitalist to make
the troika complete. Nor does the capitalist have to remain wedded to the
same inventor and entrepreneur for the entire duration of the project. Through
buying and selling gold bonds he can always go after the project that appears
most promising to him. The problem of forming optimal triangles midstream can
be safely entrusted to the bond market.
The Gold Bond and Its Sinking Fund
We have seen that the success of the capital market
depends on a versatile and standardized trading instrument, the gold bond, that can be used as (1) the standard of capital values, (2) the
balancing item of a liability on capital account. The gold bond
evidences debt payable at maturity in gold, plus it provides an interest
income in the interim, also payable in gold. The income is represented by the
coupons attached. The gold bond is traded in a broadly-based secondary
market.
It is absolutely necessary that principal and
interest be payable in gold coin. A bond that is payable at maturity in
irredeemable currency is not a financial instrument; it is a cruel joke. It
means that the underlying indebtedness will never be extinguished. It will
keep growing forever, and the danger is that its growth will ultimately
accelerate and get out of control. The bond in fact is irredeemable: at
maturity it will be replaced by another irredeemable bond, usually of
inferior quality. One should not be misled by appearances that the face value
of the bond is paid at maturity in irredeemable currency. That type of
currency is inferior even to the irredeemable bond in that it does not have a
yield. In today’s world all bonds are irredeemable. Gold bonds have
disappeared without a trace after Great Britain
and the United States
reneged on the last issues in the early 1930's. One should keep in mind that
this does not mean that there is no demand for them. It only means that the
powers-that-be would like to extirpate the memory of the gold bond in order
“to make the world safe for plunder”. We still don’t know
whether the attempt has succeeded or whether, perhaps, truth and justice will
ultimately prevail, as it always has in history so far.
A gold bond is supported by a sinking fund. It
is established by the issuer in order to make sure that the market value of
the bond does not erode with time, as it might, making the rate of interest
take a “slide” on the yield curve, a concept I shall discuss in a
moment. It is incumbent on the issuer to keep the value of the bond stable,
if need be, by retiring some of the outstanding issue prematurely. The
manager of the sinking fund is a market-maker who would buy the bond at the
lower bid price and sell it at the higher asked price. It follows that, under
a gold standard, the sinking fund would not only protect the bondholder, but
it would also be profitable to operate for the issuer.
A book on sinking funds published in 1967 (op.cit.) suggested that their operation
incurred extra costs that bondholders had to absorb in the form of lower
coupon rate. The drift of the argument was that the issuers of debt were
actually doing a favor to the bondholders in
issuing it without sinking fund protection, a practice coming into
vogue just about at that time. Of course, the suggestion that the bondholder
may be better off without the protection of the sinking fund is disingenuous.
The book was written to prepare the public for dramatic changes. Gyrating
interest rates and bond prices were about to replace stable interest rates
and stable bond prices, due to the coming destruction of the gold standard
that has cast its long shadow forward. In such an environment the sinking
fund would be exhausted in a matter of a few weeks, if not days. New
arguments had to be invented to justify new practices. The book was paving
the way to the euthanasia of the bondholder that was about to take place.
The Euthanasia of the Bondholder
The cynical phrase “euthanasia of the boldholder” was first used by John Maynard Keynes. He
was well aware what the implementation of his schemes to sabotage the gold
standard would mean to bondholder. Keynes treated the bondholder with
contempt, as a parasitic element of society. He ridiculed coupon-clipping,
calling it the only positive contribution the bondholder is capable of making
to the commonweal.
In the event, euthanasia was turned into a
bloodbath, the like of which the world has not seen since the night of St.
Bartholomew. In view of the hexagonal model, to disparage the bondholder is
tantamount to disparaging the annuitand and the
annuitant, that is, one’s father and grandfather who, after a lifetime
of faithful and diligent service expect to have a peaceful and secure
retirement. The euthanasia of the bondholder means the euthanasia of dear old
grandfather.
It is to the eternal shame of our Western
Civilization that the crime of slaughtering the bondholders was permitted and
even glorified, and no case study of the sufferings of the victims was ever
allowed to be published.
The euthanasia of the bondholder was the ill star
under which “social security” was born. The latter is a
compulsory scheme based on socialistic principles. There is no actuarially
sound way to fund the liability incurred by a universal social security
program. In fact, it is an unfunded system financed through an open-ended tax
escalator. Such a system is easy to introduce, as in the early days a
relatively large number of workers support a relatively small number of
eligible beneficiaries and the tax rate is nearly negligible. However, as the
system reaches maturity a couple of generations later, the number of workers
it will take to support one beneficiary declines drastically. This would
happen in any case, but birth control, life-prolonging drugs and therapeutic
procedures greatly accelerate the process. A reduction in promised benefits
is out of the question and is regarded as political dynamite. The only
alternative is to escalate taxes that finance the system. Just how long the
taxpayers will be willing to carry the open-ended increases of burden is
anybody’s guess. It will eventually dawn upon young people that they
will never benefit as the scheme is bound to collapse before they reach
retirement age.
Compulsion can never do what spontaneous association
can. We have seen in the previous Lecture that the “social
security” scheme introduced in the 1930's dissipates the wealth of the
annuitant and induces the annuitand to stop saving.
There is also the sinister problem of depriving the inventor of his
traditional source of financing, with incalculable consequences as to capital
accumulation, in particular the capitalization of incomes, which society
depends upon in order to provide the benefits and comfort to the retired
population. Note that none of the problems associated with the compulsory
scheme arise under the voluntary cooperation of the annuitand,
the annuitant, the entrepreneur, and the inventor discussed in the previous
Lecture.
The usual objection is that the voluntary system is
not universal and it leaves indigent people out in the cold. This is not the
place to go into a discussion of the validity of the Biblical admonition that
“the poor will always be with us” and there will always be a need
for charity, regardless of the level of affluence that society may reach. We
must reconcile ourselves to the objective fact that a compulsory social
security scheme promising universal coverage is not viable and cannot be made
viable. The idea could be sold politically only because people are prone to
fall for Ponzi schemes, to the genus of which
social security clearly belongs.
The Rise and Fall
of the Yield Curve
Nowadays one hears frequent references to the
“yield curve” or, as the case may be, to the “inverted
yield curve”. It may come as a surprise that there was no yield curve
under a gold standard. Multiple interest rates along with multiple foreign
exchange rates belong to the paraphernalia of the regime of irredeemable
currency, wherein a change in the price of crude oil, for example, could move
both rates, and an increase in prices could provoke another increase in
prices, as currency debasement looms large. Under the gold standard the rate
of interest and of foreign exchange are stable and well-protected from shocks
such as that in the price of crude oil, for example.
The yield curve represents the rate of interest as a
function of time to maturity. It is considered “normal behavior” for the rate of interest to increase as
the time to maturity is increased. Moreover, the rate of interest asymptotically
approaches a certain value, the theoretical yield of a perpetual bond, as the
time to maturity tends to infinity. This means that the normal shape of the
yield curve is that of a rising one which nevertheless is bounded from above
by the theoretical yield on perpetual bonds. A rising yield curve means that
as maturity increases, the yield also increases. This is supported by the
Principle of Time Preference (a concept that I shall discuss in a future
course Monetary Economics 202, The Bond Market and the Formation of the
Rate of Interest) asserting that, when given the choice between funds
available in the remote or nearby future, the economizing individual will,
other things being the same, choose the latter.
However, under “abnormal” credit conditions
it can and often does happen that, as maturity increases, the yield actually decreases.
In this case the yield curve is called “inverted” as it is
falling (apart from a brief sharp spike near zero maturity). It still
approaches the same value asymptotically as the time to maturity tends to
infinity, but in this case the yield curve is bounded from below by the
theoretical yield on perpetual bonds. Abnormal credit conditions mean that,
as a result of loose credit policies pursued by the banks and the government,
too many short-term credit instruments approach maturity, which depresses
their prices. Cash is scarce and the yield on short-term credit is high. The
inverted yield curve may return to its normal state quickly, or it may last
for an extended period of time, depending on the depth of the credit crisis
which always accompanies it.
None of this may happen under a gold standard where
the government and the banks are forced to keep their short-term liabilities
safely within the limits of their quick assets. In fact, if all the gold
bonds issued have sinking fund protection, as they should, then there is no
yield curve. More precisely, the yield is the same constant value for all
maturities (making the yield curve a horizontal straight line). The rate of
interest is stable, both in time and across the maturity spectrum. A yield
curve, if one existed, would create a temptation for the banks to borrow
short in order to lend long. Such an activity would lead to periodic credit
crises and the yield curve would get inverted as a result. I shall deal with
these problems in more details later in this Course.
The fact that there is no yield curve under a gold
standard does not mean that the rate of interest may not change. What it
means is that all the adjustments are so gradual that they present no
temptation for the banks to speculate in the bond market. On the other hand,
if certain economic shocks (such as a continental crop failure, or pestilence
wiping out a sizeable portion of the working force) calls for a big rise in
the rate of interest, then it will be made quickly and expeditiously. Issuers
of gold bonds will refund their obligation and sell a new issue with a higher
coupon rate. In no case would they allow bondholders to suffer a loss. They
take to heart the Biblical admonition that “tormenting widows and
orphans is a sin that cries to high heavens for punishment”.
Arbitrage versus
Speculation
I have mentioned repeatedly that there is no bond
speculation under a gold standard. Subsequently I got several messages from
my readers insisting that speculation actually has a role in stabilizing
interest rates. However, what my readers referred to as “stabilizing
speculation” is no speculation at all. It is arbitrage. The two must be
carefully distinguished, something that mainstream
economics has failed to do. The distinction becomes clear at once when we
consider the objectives of the speculator and the arbitrageur. The former is
willing to take big risks in the hope of a big payoff. The latter is not
interested in risk-taking at all. The arbitrageur steps in whenever the
market shows deviant behavior. He makes his bet
that the deviation will be corrected. Whenever a sufficient number of
arbitrageurs do likewise, their market action will be self-fulfilling. Examples
are deviations in the foreign exchange rates, or those in the rate of
interest, under a gold standard. The arbitrageur takes it for granted that
the deeds of the government are as good as its words, and it wouldn’t
knowingly mislead the market and pocket the illicit gains that originated in
deception. Of course, any arbitrageur would quickly come to grief in
today’s foreign exchange and bond markets where deception is practiced
by governments on a regular basis. It is not by accident that mainstream
economists have failed to make a distinction between arbitrage and
speculation in the bond market. They are lame apologists for the government
out to cover up bad faith and chicanery.
Arbitrageurs have vacated the field, and speculators
have taken over, as a result of the destruction of the gold standard. Contrary
to mythology, under the gold standard it wasn’t the central bank that
kept the rate of interest and foreign exchanges stable. It was the
arbitrageurs who believed in the good faith of the government in promising
payment on their obligations in gold coin at a fixed rate. Without arbitrage
the financial resources of the central bank would have been inadequate to
stabilize the foreign exchanges, as well as the rate of interest. As I have
said this is an issue that mainstream economics is unable to address. It has
no mandate from its sponsors to use the language of good and bad faith in
market dealings. However, there is no other way to deal with markets under
the regime of irredeemable currency but through pointing out the deception
regularly practiced by the government and its central bank in order to fool
the public. This is why devaluations were always announced during the
week-end when markets were closed. Prior to this government and central bank
spokesmen had shouted from the rooftop that foreign exchange rates will
“never” be changed. Next week politicians and central bankers had
to eat their words. Nowadays this problem is avoided through the mechanism of
floating foreign exchange rates. Note that “floating” is a
euphemism for “sinking”, as the international monetary system is
merely a cover for competitive currency devaluations. At any rate, the
outcome is the same: the fleecing of the producing sector (including the
savers) and the enriching of the financial sector (including the treasury).
One Rate or Two?
I have pointed out that the rate of interest is the
marginal efficiency of the exchange of wealth and income. It is determined
through a market process, similar to that determining the price of wheat. But
whereas the formation of the wheat price can be described through a simple
diagonal model with the two poles representing supply and demand, the
formation of the rate of interest is more complicated as there are at least
two types of exchanges involved. Following this line of reasoning we have
arrived at the hexagonal model of capital markets clearing all the exchanges
of income and wealth. Just as the sale of every sack of wheat has an effect
on the price of wheat, every exchange of wealth and income has an effect on
the rate of interest.
My critics point out that if my analysis were
correct, then there would have to be two rates of interest, one regulating
the exchange of the income of the annuitand for the
wealth of the inventor, and another, regulating the exchange of the wealth of
the annuitant for the income of the entrepreneur. One rate or two, that is the question.
It is true that for gold bonds, no less than for
wheat, the market quotes not one but two prices: a higher asked price and a
lower bid price. Transactions take place between these two extremes. The
spread between the two has an extraordinary theoretical importance. It is
instrumental in setting a limit to the volatility of the rate of interest. In
more detail, the higher asked price for the gold bond translates into the
floor, and the lower bid price into the ceiling, for the rate of interest.
The reason for the inversion is the fact that the
price of the gold bond and the rate of interest move inversely. It is
imperative that the reader have a good grasp and a good visual image of this
inverse movement, and the inversion of its extremities. (One way of
visualizing this inverse movement is a pair of pistons of a reciprocating
steam engine as they run up and down in their respective cylinders, always in
opposite directions. Another way is the see-saw, a piece of equipment for
children to play on, consisting of a long flat piece of wood supported in the
middle. A child sits at each end and makes the see-saw move up and down.) I
shall make frequent references to the reciprocating movements of the rate of
interest and the price of the gold bond, by calling it the
“see-saw”.
Stable interest rates under a gold standard are
explained by the small spread between the asked and bid price of the gold
bond. We may verbalize this by saying that the stability of the rate of
interest under a gold standard is the flip-side of the narrow bid/asked
spread for the gold bond. By contrast, wildly gyrating interest rates, as
experienced under the regime of irredeemable currency, reflect the yawning
gap between the asked and bid prices of bonds. The gap is the only clue we
have to explain unstable credit conditions.
So why is there a unique rate of interest under a
gold standard when, on the face of it, there ought to be two, one at which
income is exchanged for wealth, and another at which wealth is exchanged for
income? Here is the reason why. Those who want to exchange wealth for income
are the buyers, and those who want to exchange income for wealth are the
sellers of the gold bond. To say that the two rates, one involved in
exchanging wealth for income and the other income for wealth, are not equal
is the same as to say that there is a wide gap between the asked and bid
prices of the bond. The investment banker and the managers of various sinking
funds act as market-makers in the bond market. They buy the gold bond at the
lower bid price and sell it at the higher asked price. They profit from the
existence of a wide spread between the two. As a result of their arbitrage
the spread narrows and the two rates get closer. Even though profits from
this arbitrage disappear together with the spread, the investment banker and
managers of the sinking funds will continue in this business. Their primary
task is not to profit from the arbitrage; it is to make a market in bonds. We
conclude that under a gold standard the bid/asked spread of gold bonds is
negligible, and for all practical purposes the rate of interest is one and
the same for all maturities.
Deterioration in the Quality of
Credit
If the bid/asked spread for bonds widens, it means
that the market-makers in the bond market are hampered in their bid/asked
arbitrage. Either the sinking fund protection of bonds is being withdrawn, or
the investment banker is intimidated by a torrent of new inferior bond
issues. The widening in the bid/asked spread measures the deterioration of
credit.
In these terms, the 20th century
witnessed an unprecedented deterioration in the quality of credit, one that
mainstream economists prefer to ignore. The landmark was the
government’s default on its gold obligations. This was followed by the
dismantling of the sinking fund protection of the bondholders. Finally, the
gold clause on bonds were declared “contrary to public purpose”
by the government. As a consequence arbitrageurs have abandoned the field and
speculators have taken over. The latter are now in the driver’s seat,
and bond speculation is increasing by leaps and bounds.
In the 19th century self-respecting
governments and companies would not have tolerated that the value of their
obligations become a plaything in the hands of speculators. As a matter of
fact, there were no bond speculators since there was not enough volatility in
the price of the gold bond to make speculation profitable. Things are very
different today. Ever since the last link between the dollar and gold was
severed in 1971, the volume of bond speculation has been increasing at an
exponential rate. Today gold bonds are historical relics. Governments
won’t put up with any meaningful competition against their obligations
denominated in irredeemable currency. They know full-well that their issues
would not stand a chance in such an environment.
A gold bond is an obligation that is payable, not in
terms of itself, but in value existing outside and independently of
the promises of the issuer. A government bond of current vintage is an obligation
redeemable in an inferior instrument: a non-obligation, to wit: in
non-interest-bearing irredeemable currency. This shatters the logical basis
supporting the value of the bond. But this is not all. Ostensibly the value
of irredeemable currency is supported by the assets against which they are
issued as a liability on the books of the central bank. As these assets are
the very same government bonds which promise to pay irredeemable currency to
the bondholder at maturity, the logical basis supporting the value of the
currency is shattered, too. The relationship between the government bond and
the currency is an incestuous one, on which it is not possible to build
long-term prosperity. These are fundamental problems that are not being
addressed while fair weather lasts. In the meantime forces promoting foul
weather are gathering steam. It is doubtful that these fundamental problems
can be dealt with after the storm has begun.
Fleecing
the Producers
If the logical basis for the value of government
bonds has been shattered as it promises to pay its face value in nothing but itself, the question arises what then supports the value
of these bonds? The answer is that government bonds are the very chips one
needs in order to play in the casino otherwise known as the bond market.
The destruction of the gold standard by the
government was thoroughly immoral, but the matter did not end there. It has
corrupted the bond market right to its core. Today nobody in his right mind
would try to save by holding the bond to maturity. The bond market is the
haunt of speculators. It is a casino for gambling. The bond is the chip to be
used at the gambling tables. Yet there is an important difference between the
operation of the bond market under the regime of irredeemable currency, and
the gambling casino. In the latter the gains of one gambler is the loss of
another. This is also expressed by saying that gambling at the casino is a
zero-sum game. Its effect on society at large is nil.
It is quite otherwise with bond speculation. Here we
have a casino wherein the players can fleece outsiders. In a later Lecture I
shall deal in full details with bond speculation and its effect on saving and
production. Let it suffice here to state the bare fact that the bond market
is a casino where speculators risk not their own funds but those of the savers
and producers. As a result, the latter are always the losers, even when they
haven’t the slightest intention to play. We have an insane arrangement
whereby productive activity is penalized and gambling activity is rewarded. As
a result, the volume of productive activity constantly shrinks while that of
financial activity constantly expands. Moreover, the latter expands at an
exponential rate, as the financial markets attract all available funds,
gobbling up the capital of the producing sector. Most ominous of all, talent
is no longer attracted to production, entrepreneurship, and inventive
activity. Capable young people choose vocations related to the financial
sector, the only place where they can hope to earn adequate rewards.
To recapitulate, under a gold standard capital
markets function efficiently to channel the funds of savers to finance
production for the benefit of the entire society. Their operation is
accurately described by the hexagonal model which in particular explains the
formation and stability of the rate of interest. Capital markets have been
corrupted by the destruction of the gold standard. The rate of interest has
been destabilized, inviting bond speculators to turn the capital markets into
a gambling casino where the producers and savers can be fleeced. The moral
responsibility for this subversion must be borne by the government and the
profession of the economists for its failure to inform the public of what is
happening.
References
F. Corine Thompson and
Richard Norgaard, Sinking Funds - Their Use and
Value, New York:
Financial Executives Research Foundation, 1967
March 1, 2004
Antal E. Fekete
Professor Emeritus
Memorial University
of Newfoundland
St.John's, CANADA A1C5S7
e-mail: aefekete@hotmail.com
GOLD UNIVERSITY
SUMMER SEMESTER, 2002
Monetary
Economics 101: The Real Bills Doctrine of Adam Smith
Lecture
1: Ayn Rand's Hymn to Money
Lecture 2: Don't
Fix the Dollar Price of Gold
Lecture 3: Credit
Unions
Lecture 4: The
Two Sources of Credit
Lecture 5: The
Second Greatest Story Ever Told (Chapters 1 - 3)
Lecture 6: The
Invention of Discounting (Chapters 4 - 6)
Lecture 7: The
Mystery of the Discount Rate (Chapters 7 - 8)
Lecture 8: Bills
Drawn on the Goldsmith (Chapter 9)
Lecture 9: Legal
Tender. Bank Notes of Small Denomination
Lecture 10: Revolution
of Quality (Chapter 10)
Lecture 11: Acceptance
House (Chapter 11)
Lecture 12: Borrowing
Short to Lend Long (Chapter 12)
Lecture 13: The
Unadulterated Gold Standard
FALL SEMESTER, 2002
Monetary
Economics 201: Gold and Interest
Lecture
1: The
Nature and Sources of Interest
Lecture 2: The
Dichotomy of Income versus Wealth
Lecture 3: The
Janus-Face of Marketability
Lecture 4: The
Principle of Capitalizing Incomes
Lecture 5: The
Pentagonal Structure of the Capital Market
Lecture 6: The Hexagonal Structure of the Capital Market
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