In Part I (http://keithweinereconomics.com/2013/04/22/th...rt-i-linearity/),
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 target="_blank"(http://keithweinereconomics.com/2013/05/15...t-ii-mechanics/),
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.
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.
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.
target="_blank"
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 the speculator is
due entirely to the perverse incentives created by coercive government interference.
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.
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.
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.
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.
target="_blank"
[1]< target="_blank"/a> http://keithweinereconomics.com/2012/01...terfeit-credit/< target="_blank"/p>
[ target="_blank"2] http://keithweinereconomics.com/2012...omes-permanent/ target="_blank"a>
[3] See my dissertation
for an extensive discussion of government inte target="_blank"rference: A
Free Market for Goods, Services, and Money target="_blank"a>
[4] The
Unadulterated Gold Standard Part III (Features) target="_blank"a>
[5] Interested readers
are referr target="_blank"ed to the subsite on
Professor Antal Fekete's website where he presents his theory of interest
and capital market target="_blank"s.
[6] Antal
Fekete: Gold Backwardation and the Collapse of the Tacoma Bridge with
Anthony Wile