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- The Second Greatest
Story Ever Told, Chapters 7-8 -
- One Discount Rate or Many? -
- Arbitrage -
- The Rise and Fall of the Discount House -
One Discount Rate or
Many?
In the previous Lecture I explained how
discounting bills of exchange was invented, how the discount rate appeared,
and how changes in the propensity to consume made it go up or down. I also
presented the important argument that the discount rate is entirely different
in origin and nature from the rate of interest.
We still have one mystery to solve, namely the
question: Is there one discount rate or are there many discount rates? Is the
clothier discounting at one rate and the baker at another, or are all
retailers discounting at the same rate? The next Chapter in The Greatest
Story Ever Told will answer that problem.
Chapter Seven
in which the gentle reader learns why the baker discounts at the same rate as
the clothier
The clothier noticed that
his success in trading bills of exchange attracted imitators. The miller was
also drawing bills on the baker and used them to pay the grain merchant for
the wheat, after the bill was accepted by the baker. In holding the
miller-on-baker bill the grain merchant was earning an income on his idle
cash, just as the spinner, holding the weaver-on-clothier bill, was earning
an income on his. Both men knew that they could use their bills to pay their
suppliers, or anyone else for that matter. They were also confident that if
they ever needed gold coins for any reason, they could get them by
discounting their bills with another merchant experiencing a temporary
overflow of cash.
The clothier had a
penchant for inquiry. He was anxious to find out at what rate the baker was
discounting the miller's bills. Was it the same rate he was using himself, or
a higher/lower rate? To his amazement he found that the baker was discounting
at exactly the same rate. Whenever he had reason to change the discount rate,
so had the baker, moreover, the adjustment was by the same amount and in the
same direction. As there was no collusion, it appeared to the clothier that
an 'invisible hand' was guiding them and made the adjustment every time a
deviation between their respective discount rates was in the offing. The
clothier was fascinated by his discovery and was determined to get to the bottom
of it.
It came to pass that the
summer was unusually dry and it did great damage to the cotton crop while
actually helping the wheat harvest. The clothier noticed that his suppliers
were anxious to discount their bills, in spite of the higher discount rate he
was posting. They would rather take the gold coin instead of holding the
bill. Meanwhile the discount rate posted by the baker actually went down. The
clothier's reaction was immediate and dramatic: he sold all the
miller-on-baker bills in his portfolio and used the proceeds to buy back all
the weaver-on-clothier bills that were still floating out there. He reasoned
that the discrepancy between the discount rates must disappear by the
maturity date at the latest, and he could pick up some riskless profits by
the maneuver of getting out of bills discounted at
the lower and getting into bills discounted at the higher discount rate. In
other words, the clothier sold bills at the higher and bought them at the
lower price, and expected to profit from the equalization of the discount
rates.
The weaver was following
these maneuvers of the clothier with fascination,
and offered a bet. He was betting that the price of bread would go down as a
result of the good wheat harvest, and the price of cloth would go up as a
result of the disastrous cotton crop. His thinking was conditioned by
'conventional wisdom' asserting that a good crop means lower and a bad one
means higher prices. The clothier won the bet hands down. There was no change
in the price of the bread, nor in the price of
cloth. Moreover, the spread between the two discount rates completely
disappeared.
The clothier would not
kid himself that all this was due to his intervention in the bill market. He
was candid enough to admit that other factors were at work, too. Cotton
merchants from other regions not affected by the dry summer were attracted by
the higher discount rate. They drew bills against their shipments of cotton
to the area afflicted by the drought. Meanwhile, merchants back home were
drawing bills against their shipment of grain to other places with a poor
grain harvest, where the discount rate was higher. These operations called
'arbitrage' had the effect of equalizing the discount rates on cloth and
bread. They also explained why there was no rise in the price of cloth, nor a
fall in the price of bread. The spread in the discount rate attracted cotton
to the area of shortages, and expelled grain from the area of surpluses. The
reason for price changes disappeared before they could materialize.
Arbitrage
The clothier deserved to win the bet since he
had the better grasp of the fundamentals of bill trading. The weaver failed
to understand that a discrepancy between the discount rates on cloth and on
bread is an aberration that was bound to disappear in short order due to the
arbitrage of those who understood the bill-trading process. Arbitrage
means buying in one market while selling in another (the two markets may also
be the same as a special case) motivated by the arbitrageur's expectation of
a certain change in the spread The spread is defined as the difference
between prices at which he has bought and sold. In our example, the
weaver-on-clothier bill was bought at a lower and the miller-on-baker bill
was sold at a higher price (due to a higher discount rate on the former and a
lower one on the latter). By maturity the prices, on average, would be
equalized. The arbitrage opportunity of which the clothier availed himself
promised him risk-free profits.
Economists haven't paid sufficient attention
to the spread and arbitrage, concentrating their efforts on the price and
speculation instead. Yet the fact is that arbitrage and speculation are
diametrically opposed to one another. The speculator takes large risks in the
hope of large profits. The arbitrageur is not interested in increasing risks:
he is interested in reducing them. The fact is that the price is subject to
so much diverse and capricious influence that predicting its changes is a
risky business. By contrast, spreads filter out a good many of these
capricious effects on individual prices. Well-informed businessmen know this
and, with a solid understanding of the economic factors they can spot the
spreads that are out of line and predict in which direction they will move.
In these Lectures I shall concentrate on the guiding star of business: the
spread, and describe arbitrage as the principal form of human action, the
tool par excellence of successful businessmen who provide the driving
force behind the changing economic landscape.
In the previous Chapter we saw several
examples of arbitrage, and I am asking you to study each one separately. In
addition to buying the weaver-on-clothier bill at the lower, against selling
the miller-on-baker bill at the higher price, we also saw that if wheat was
cheaper in country A and a more expensive in country B, then
the arbitrageur would buy it in A and sell it in B. Also, if
the discount rate was higher in A and lower in B, then the
arbitrageur would buy the bills drawn on country A (where bills were
cheaper) and sell the bills drawn on country B (where bills command a
higher price). Arbitrage is the most important tool to reduce risks in
economic activity. The previous examples are related to inter-spatial
arbitrage. Warehousing provides examples for inter-temporal arbitrage.
Take a grain merchant who buys grain in the fall to fill his grain elevators.
His problem is that he will need an exorbitant amount of capital in order to
be able to shoulder the risk that the price of his grain in the elevators
might drop. He solves the problem by going to the grain futures market where
he sells forward an equivalent amount of grain. Using another word, he is hedging
his inventory of grain in his elevators. As he is selling grain from his
elevators, he will lift a matching number of his hedges in the grain futures
market. Hedging gives the grain merchant protection against falling grain
prices. For losses on grain held in the elevator he is compensated by capital
gains on the hedges.
Chapter Eight
in which the gentle reader learns why the clothier was in such a hurry to go
out of the cloth business
Soon afterwards the
clothier sold his store and went out of the cloth business. He had a better
idea. He would trade bills drawn by one tradesman on another against
shipments of consumer goods. The clothier was in a hurry. He assumed that
other clever traders might be planning to do the same thing, and he wanted to
get a piece of the action.
With a good grasp of the
needs of tradesmen the clothier knew exactly where and when to buy bills, or
where and when to sell them. He would buy bills drawn on a tradesman whose
business was slack temporarily, but who were about to enter their high
season. He would sell bills to tradesmen whose wares were moving pretty fast
at the moment, but who were about to enter their slack season. In September
he would buy bills drawn on the coal-merchant, and offer bills for sale to
the grain merchant. The former was building up an inventory of coal for the
coming winter heating season, and bills on coal were relatively cheap. The
latter was drawing down his inventory of grain and was looking for liquid
earning assets where he could park his idling circulating capital until the
next harvest.
The clothier knew from
his own experience that the inventory of bills in the portfolio of a retail
merchant was complementary to the inventory of merchandise on his shelves.
Both were earning assets to the retailer, albeit in a different way. The
incomes from the two inventories see-sawed with the seasons. The retailer,
while keeping the combined value of the two at about the same level, would
let the mix vary with the change of the seasons. In this way the retailer
could, with the help of the special bill-trading services offered by the
clothier, mitigate or eliminate the seasonal character of his business. He
would compensate for the decline of income in his low season by increasing
the income from his bill-portfolio consisting of bills drawn on merchants in
their high season. Then at the start of his high season he would draw down
his inventory of bills and use the proceeds to build up his inventory of
merchandise. As his income from the bill portfolio declined, so would his
income from the inventory of merchandise increase.
The clothier called his
new business the "Discount House". He also offered other special
services to his clients, such as collecting the face value of bills at
maturity from the acceptor. He was making a market in outstanding bills: he
would be ready to buy bills from one client who unexpectedly found himself
short of cash, or to sell bills to another who unexpectedly found himself
with more cash than he needed for the conduct of his business.
The Role of the Discount
House
This is how the Discount House specializing in
market-making for bills of exchange was born. It has extended the scope of
bill circulation greatly. Of course, bills could circulate in the absence of
the Discount House, too, but circulation would be limited to a small circle
of merchants in business contact with one-another, such as the spinner, the
weaver and the clothier. Now, with the intermediation of the Discount House,
one merchant could buy the bill of another even if he was not personally
acquainted with him. He relied on the expertise of the Discount House
concerning the security of the paper he was buying. A lot of new businesses
sprang up to satisfy the seasonal needs of the consumer which could not
formerly prosper as a result of the exorbitant capital costs involved in
carrying seasonal merchandise. These capital costs were now drastically
reduced, as a result of the expansion of bill circulation, thanks to the
operation of the Discount House helping to finance trade in seasonal consumer
goods.
It may help us understand the bill market
better if we contemplate that the market process in effect gives temporary
and ephemeral monetary privileges to the bill of exchange drawn of
fast-moving merchandise on its way from the producer and distributor to the
consumer, as I have suggested earlier. Indeed, consumer goods circulate, and
their circulation is fueled by two of the most
important human instincts, survival and recreation. Monetary circulation of
consumer goods in natura is hardly possible.
Bills of exchange make consumer goods circulate by proxy, as it were. There
is no risk involved in holding the bill. Payment at maturity is a virtual
certainty. The underlying consumer goods are know to exist and to be in demand. Shortages of
gold, real or imagined, will not hamper the liquidation of the credit drawn
against the movement of consumer goods. At maturity the consumer's gold coin
will liquidate not only the liability of the last endorser of the bill, but
that of all the previous endorsers as well. This is what makes the credit
represented by the bill of exchange self-liquidating.
The Highjacking
of the Social Circulating Capital
Compare two scenarios: the first in which the
Discount House operates in the absence of a Commercial Bank, and the second
the other way round, in more details, the Commercial Bank is the only place
where merchants can discount their bills which then become the earning asset
of the bank. One might say that the two credit systems are economically
equivalent. However, there is a significant difference. Full disclosure is
achieved only under the first scenario. Here bills are openly traded:
everybody is free to inspect all the bills offered for sale. Fraud is nearly
impossible, as traders would quickly spot a bill drawn on a stalled good, or
a higher-order good, or multiple bills drawn on the same merchandise. Nor
would it be possible to 'roll over' a bill at maturity. There is
transparency, every trade in the credit market is under public scrutiny, and
every trader is an umpire who would blow the whistle if he saw an irregularity.
Under the second scenario "banking
secrecy" covers up most information that the public should be entitled
to have. The portfolio of the commercial bank may shelter a lot of illiquid
or slow bills that the Discount House would reject outright, such as bills
drawn stalled goods, or on higher order goods, or multiple bills on the same
good. At maturity a bill may be redrawn, in other words, the absolute ban on
extending maturity beyond 91 days could easily be violated under the cover of
secrecy provided by the Commercial Bank. The temptation to cheat would be
great.
But perhaps the most important shortcoming of
the second scenario is in the perverse perceptions created, making the banker
the boss and the tradesmen discounting their bills at the bank merely his
clients dependent on his favors. In reality the
tradesmen are the boss and should be so perceived, while the banker is their
servant. After all, the credit being traded is rooted in the momentum of the
consumer goods that the tradesmen are moving to the ultimate cash-paying
consumer. The banker's job is not that of rationing credit, which is the ruling perception, but that of clearing it,
shifting it from one tradesman who no longer needs it to another who does in
the task of moving merchandise most efficiently from the producer to the
consumer.
But it is this perverse world is what we have
got. The Discount House has been forced out of business by the Commercial
Bank in a coup. The latter has preempted the
business of the former, taking over and monopolizing its functions. The
Social Circulating Capital has been hijacked. Formerly it was under the sole
control of the tradesmen moving consumer goods along to the consumer with all
deliberate speed. The tradesmen used to recognize only the sovereign
consumer. Now they cringe before their new boss, the banker, who in turn does
not recognize the sovereign consumer. In this way the tradesmen, like the
mythological hero Anteus, have been cut off from
their natural source of strength, the Social Circulating Capital. The source
of strength of Anteus was Mother Earth, and he had
to touch her every so often to replenish his strength during the fight. His
enemies, privy to his secret, could cause his downfall by holding him up in
the air and wrestling him to death that way. The tradesmen are losing the
fight as the monopoly of the Commercial Bank over the Social Circulating
Capital has made it impossible for them to raise credit directly from it. The
hijacking of the Social Circulating Capital was a very unfortunate
development to which I should have to return in a future Lecture.
Efficiency of the Gold
Coin
The bill market has made the gold coin
extremely efficient, far beyond its physical capability to circulate. The
limitation on improvements in production and distribution technology through
refining division of labor further has been
removed. The bill market has made the monetary system more elastic and more
responsive to the needs of the consumer. Any type of good can generate bill
circulation, provided that the consumer demands it urgently enough. By the
same token, bills representing goods that have just fallen out of the
consumers' favor are immediately demonetized. As
the bill market works only with short maturities (never ever exceeding 91
days) it will adapt itself quickly and smoothly to the changing whims of the
consumer. The bill market is characterized by its near-perfect flexibility,
adaptability, and elasticity. Consumer prices no longer depend on the greater
or lesser availability of gold coins. If the consumer demands an item
sufficiently urgently, then its production and distribution can be financed
instantaneously through drawing bills against its movement. The volume of
bills flows and ebbs with the volume of merchandise trade, eliminating both
price squeezes and price explosions.
The principle of granting certain limited and
ephemeral monetary privileges to the bill of exchange is a sound one. It
recognizes the fact that a market relying solely on the circulating gold coin
could not handle the extra, unexpected, or changing burden that might be
thrown upon it by the proverbially erratic behavior
of the consumer. Thanks to the flexibility of bill circulation, it is the
consumer, and the consumer alone, who ultimately decides what ought to be produced,
when, and how much. In the market every day is balloting day. The consumer's
ballot paper is made of gold. He casts his ballot by plunking down the gold
coin on the retail counter. The distributors and producers of merchandise in
whose favor he has cast his ballot, no less than
the others he chose not to favor, will certainly
get the message.
It is very important for you to see that it
is not the price-system that communicates this message from the consumer to
the producer. Temporary changes in the demand for
staple consumer goods (such as food, clothes, fuel) does not give
occasion to changes in the price. The price-system in and of itself is
neither sensitive nor quick enough to accomplish the task of alerting the
merchants to the impending changes in the mood of the consumer. The message
concerning changes in the propensity to consume is communicated to the
distributors and producers, not through changing prices, but through changes
in the discount rate (and the composition of the social circulating capital,
as I shall explain it in a later Lecture). Changes in the discount rate
respond quickly and sensitively to the changes in consumer demand. The
lubricating mechanism that guards the movement of goods against seizing up
when changing to high or low gear is the bill
market. Without it, roundabout production processes (making the evolution of
goods of ever-higher order possible) could not exist. Without it, the
internal communication system of the economy would be overloaded.
Mises on Fiduciary Credit
As I have suggested in earlier Lectures, my
presentation of the evolution of fiduciary currency deviates substantially
from that of Ludwig von Mises. It is now time to
scrutinize this deviation more closely. Mises
divides credit into two large categories, according as the party extending
the credit does or does not have to make a 'sacrifice'. So credit belonging
to the second category is created 'gratuitously'. Mises
calls it fiduciary credit, while calling the currency to which it gives rise
fiduciary currency.
Mises admits that the concept of fiduciary credit may
appear "puzzling, even inexplicable; it constitutes a rock on which many
an economic theory have come to grief" (op.cit., p.
297). The bank is creating something out of nothing. Mises
specifically criticizes the opposite view (ours) suggesting that when the
bank discounts a bill, it merely substitutes its own credit which is more
negotiable and has a higher recognition value, for credit represented by the
bill which is less negotiable and has a lower recognition value. "The
fundamental error [in this explanation] lies in its failure to understand the
nature of the issue of fiduciary media. When the bank discounts a bill . . .
it exchanges a present good for a future good . . . [T]he issuer creates the
present good . . . practically out of nothing" (op.cit.
p 341).
Mises doesn't refer to clearing in connection with the
emergence of fiduciary credit, although he uses the term 'circulation credit'
(Zirkulationskredit) as an alternative name for it,
as opposed to 'commodity credit' (Sachkredit) which
is an alternative name for credit of the first category. Nor does Mises raise the possibility of fraud by the bank when it
pretends that it has the power to create something out of nothing by
extending fiduciary credit. I find it impossible to go along with Mises' view that the bank, or anyone else for that
matter, can create present value out of nothing at (nearly) zero cost. There
must be a cost born by someone. Those bearing it may not be aware that they are
being victimized by the banks, as the prestidigitation is well-hidden by
fraud. But there is a cost. The denial of it this is equivalent to asserting
that the banks have supernatural powers.
The failure of Mises
to distinguish between two types of fiduciary credit, namely, credit emerging
as a result of clearing, and credit emerging as a result of fraud, has led
him to dismiss Adam Smith's Real Bills Doctrine as a deus
ex machina. Adam Smith's theory, unlike that of
Mises, admits that circulation credit may arise
through spontaneous bill circulation even in the complete absence of banks.
This makes it plausible that fraud may appear when the banks enter the scene
and establish their monopoly of creating fiduciary credit. I can only
speculate that the aversion of Mises to the Real
Bills Doctrine was due to his unconditional adherence to the Quantity Theory
of Money. At any rate, this unfortunate aversion led Mises
to create a faulty theory of credit.
For another recent interpretation of the
monetary and credit theories of Mises see the
Internet publication Mises on Money
by Gary North, who presents the opposite view. My
readers can compare the two and are in an excellent position to make up their
own mind.
The great evil of our age, unlimited credit
expansion, cannot be understood, still less corrected, on the basis of a
faulty theory of credit. This is the reason why I have taken the trouble, and
liberty, to develop a new theory which will restore Adam Smith's Real Bill
Doctrine to its proper place, and will draw attention to the fact that it
is possible to replace the banking system in a modern economy with real bill
circulation, provided that the Mint is opened to gold first.
References
Ludwig von Mises, The
Theory of Money and Credit, Indianapolis: Liberty Classics, 1980 (first
published in 1912)
Gary North, Mises
on Money, Part 4: Fractional Reserve Banking, January, 2002, www.lewrockwell.com/north86.html
Note. The characters of the cotton dealer, the
spinner, and the weaver in my Second Greatest Story Ever Told were
borrowed from Mises (op.cit.
p. 345).
* * *
Just Leave Them Enough
Rope to Hang Themselves
My efforts here at Gold-Eagle University to
work out a blueprint for the return to a gold standard and thereby to escape
credit collapse were rewarded by J.N. Tlaga. He
came out with a critique of my plan (At First for Buses Only, www.gold-eagle.com/editorials_02/tlaga072902.html). Mr. Tlaga
had also put forward a blueprint of his own (The Alternative Future, www.gold-eagle,com/editorials_01/tlaga112801.html).
My own credentials to devise a blueprint for
monetary reform include a 5-year tour of duty on Capitol Hill. In 1985 Former
Congressman W. E. Dannemeyer of California invited
me to work in his Congressional office as his advisor on fiscal and monetary
reform. Mr. Dannemeyer
was to lead a delegation of ten Republican Congressmen to the White House.
The only item on the agenda was monetary and fiscal reform. I was entrusted
with the task of preparing a draft proposal for the perusal of President
George Bush. We have considered the inclusion of an outright return to a gold
standard. The stumbling block was the 'fixing' of the gold price. Whatever
consensus might exist in favor of a gold standard,
it would be wrecked as soon as a specific number was proposed as the official
price of gold. Debtors and creditors would never agree on the same number. My
proposal was that, as a preliminary, we should recommend a more modest plan.
We should call for the refinancing of government debt in terms of gold bonds
- a medicine American money doctors on an errand of mercy to Moscow had
prescribed for the moribund Soviet economy only a few months earlier, at the
eleventh hour. In other words, I proposed that the rate of interest should be
stabilized first, and the dollar afterwards. In October, 1989, the delegation
under the leadership of Mr. Dannemeyer
met President Bush in the Oval Office and presented the Gold Bond Plan. The
President listened intently, and instructed his Secretary of the Treasury,
also present at the meeting, to schedule a conference of his staff and that
of Mr. Dannemeyer to
prepare the final draft on the proposal. The conference was scheduled and
rescheduled three times by Treasury officials, before I realized that I was
wasting my time in Washington and left. So much for the power of Presidents
to make a first very tentative step to a gold standard, in the face of what Mr. Tlaga colorfully
describes as the opposition of "armed gangsters".
In all the previous historic experiments with
irredeemable currency there was competition: there were other
countries still on a metallic monetary standard. In every instance, the
experiment was a miserable failure, and irredeemable currency suffered an
ignominious defeat, in full view of the whole world. The present experiment
is the first in history in which the promoters of irredeemable currency take
no chances and exclude competition altogether. Even the tiniest of countries
is forbidden to adhere to a gold standard, by the revised statutes of the
IMF. By opening the U.S. Mint to gold, and by revoking the legal tender
protection of the irredeemable dollar (which the U.S. House of
Representatives could order by a simple majority vote, on the strength of its
Constitutional prerogatives) irredeemable currency could have competition
once more. This would not be an "At First Buses Only" experiment.
It would be a challenge of gold money to the hegemony of paper money. If the
challenge was turned down, it would in itself be a victory. The opponent
would be seen not to have accepted it for fear of defeat. For fear that the
irredeemable dollar would lose against gold, as has every one of its
predecessors: the continental, the assignat, the mandat, the Reichsmark, to
mention but a few, did before it.
In Mr. Tlaga's blueprint "The Alternative Future", the
monetary reform would have to live the odium down of robbing innocent people
of their life savings through repudiation of paper currency, bank deposits,
and debt. Why burden the new monetary regime with that odium, when the managers
of the irredeemable dollar are so eager to shoulder it? Just leave them
enough rope. There can be no doubt that, given free competition between the
Gold Eagle coin and the irredeemable paper dollar (minus its legal
tender protection), the depreciation of the latter will greatly accelerate,
and the agony of "waiting for Godot" will
soon be over. After all, gold is
gold, and paper is paper.
August 12, 2002
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: Illicit Interest Arbitrage
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 Definition of the Rate of Interest
Lecture 7: The Gold Bond
Lecture 8: The Bond Equation
Lecture 9: The Hexagonal Structure of the Capital Market
Lecture 10: Lessons of Bimetallism
Lecture 11: Aristotle and Check-Kiting
Lecture 12: Bond Speculation
Lecture 13: The Blackhole of Zero
Interest
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