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•Hoarding
and Dishoarding • Marginal Saving • Marketability • The
Marginal Utility of Gold • Critique of Existing Theories •
Propensity to Hoard and the Rate of Interest • Dichotomy False: Present
vs. Future Goods • Dichotomy True: Income vs. Wealth • Principle
of Capitalizing Incomes • Structure of Capital Markets • The
Square Model Featuring the Annuitand, Annuitant,
Entrepreneur, and Inventor • The Pentagonal Model Featuring the
Capitalist • The Hexagonal Model Featuring the Investment Banker
• The Concept of Interest • The Propensity to Save and the Rate
of Interest • Gold Standard, the Stabilizer of the Economy •
Disequilibrium Theory of Price Formation • Disequilibrium Theory of the
Formation of Interest Rates • The Gold Coin and the Rate of Interest
• A Tale of Two Schools • The Gold Coin and the Rate of Interest
• Interest under the Regime of Irredeemable Currency • The
Ratchet and the Linkage • Between Scylla and Charybdis •
Hoarding and
Dishoarding
In this course I set out to develop a new
theory of interest. Very little of what I have to say can be found in the
existing literature. Here I make a new departure in introducing interest as
the obstruction to gold hoarding that would be unlimited in the absence of
interest, since the marginal utility of gold is constant. (Recall that, by
contrast, the marginal utility of a non-monetary commodity does decline,
setting a limit to hoarding). In this sense interest is analogous to a
parking meter on a busy street which limits the demand for parking space that
would be unlimited otherwise.
The cyclical nature of the physical and
biological universe has prompted acting man to hoard the means of sustenance
since time immemorial. While some animals also hoard (such as bees,
squirrels), they do so instinctively and may 'forget' the size and location
of their hoards. Man does hoard consciously and systematically. As shown in
the Genesis through the example of Joseph (41: 34-36), hoarding is
necessary during the seven fat years in order to provide the wherewithal
through dishoarding during the seven lean years that are bound to follow.
Today it is customary to ridicule the innate hoarding habits of man as being
primitive and atavistic, pointing out that savings denominated in
irredeemable currency are far superior, and they can be used for the same
purpose with good effect. However, man can ignore the Biblical admonition
only at his own peril.
Marginal Saving
As gold hoarding has been discouraged and
sometimes severely punished by the powers- that-be, the theory of interest
must also include a more general treatment of the hoarding of marketable
goods which we shall call marginal saving. It is a proxy for gold hoarding
and it has, for better or worse, survived to this day. The fact is that
people always have saved in the form of hoarding marketable goods, regardless
of the availability of gold and the attractiveness of fiduciary forms of
savings and, probably, they always will. As we shall see, this residual
hoarding or marginal saving influences, and is influenced by, the rate of
interest. Unlike gold hoarding, marginal saving could not be prevented
through coercion. No sooner does the government outlaw the hoarding of one
marketable commodity than people will start hoarding another.
Marketability
The twentieth century witnessed the dismal
failure of governments to provide an honest and reliable currency to serve as
the common denominator for savings. Savers are continuously plundered as
their savings are siphoned off through currency depreciation and debasement.
One can hardly fail to see in this the ultimate incentive to hoard marketable
commodities as marginal saving. However, it is important to see that even
under the most stable monetary system marginal saving is present. For
example, under the gold standard provident and thoughtful people found it
necessary, natural, and prudent to keep a hard core of their savings in the
form of various highly marketable goods. Their foresight was justified by
later developments, as unprincipled governments have resorted to surprise
devaluations combined with the criminalization of the ownership of gold, in
order to prevent savers from using the monetary metal as a prophylactic
against plunder through currency debasement.
It is therefore logical and necessary that an
investigation into the phenomenon of interest should start with the problem
of marketability and its two variants, salability
and hoardability -- those qualities that were
instrumental in promoting gold as monetary metal. Theory and history show
that as a result of an evolution lasting for centuries if not millennia, gold
has become the most saleable as well as the most hoardable
asset. De-monetization in 1971 did nothing to change that fundamental fact.
In particular, the value of gold, unlike the value of all other goods, is
objective -- as witnessed by the enormous size of the stores of gold
(relative to current production) that private and public holders are willing
and eager to carry in the balance sheet without any promise of return to
capital, far in excess of their possible need for it. This is what makes
gold the monetary metal par excellence. By contrast, the value of
other goods is subjective. Of course, ultimately, the objectivity of the
value of gold also has subjective roots. It has to do with the superb
confidence of countless individuals (both living and deceased) in the
reliability of gold as a store of value. Out of this subjective judgment has
grown the objective fact that the store of gold in the world today is a high
multiple of annual flows (at the present rate of output the stores-to-flows
ratio for gold is in the order of 80, meaning that the stores of gold in the
world are equivalent to eighty years of production). By contrast, for other
goods the stores-to-flows ratio is a small fraction (in the case of copper,
for example, it is about 0.25, meaning that the stores of copper in the world
are equivalent to three months' production). If the stores-to-flows ratio for
copper approached that of gold, then the value of copper would approach zero
in the manner of that of drinking water, due to copper's declining marginal
utility. Under these circumstances it is hardly reasonable to suggest that a
theory of interest could ignore the fact of gold hoarding.
The Marginal
Utility of Gold
According to Carl Menger,
subsequent units of a commodity are valued less by the economizing individual
than units acquired by him earlier. This is known as the Axiom of Declining
Marginal Utility. If we rank commodities according to the rate of this
decline, then we shall find that the marginal utility of one of them declines
more slowly than that of any other. The commodity with this property is none
other than gold. In fact, the marginal utility of gold declines so slowly
that it is practically constant. It follows that gold hoarding must be
limited by something other than declining marginal utility so that the demand
for gold may not become arbitrarily large, and gold coins may stay in
circulation. The fact is that the demand for gold is limited by the positive
rate of interest channeling gold into monetary
circulation, away from hoarding.
Ludwig von Mises in Human
Action denies that the marginal utility of gold is constant (op.cit., p 404). His reasoning is that constant marginal
utility would mean infinite demand, which is contradictory. Thus, then, Mises failed to grasp the connection between gold and
interest. Elsewhere in his book (p 205) Mises
denies that it is possible to construct a unit of value because two units of
a homogeneous supply are necessarily valued differently, according to the
Axiom of Declining Marginal Utility. Yet gold has successfully furnished the
unit of value for thousands of years to many a flourishing civilization
including our own. Later we shall see that our theory of interest departs
from that of Mises in a number of other respects,
too.
Critique of
Existing Theories of Interest
Implicit in this approach is a critique of
existing theories of interest. While they recognize that hoarding has been a
primitive form of saving in earlier times, existing theories tacitly assume
that in an advanced industrial society with well-developed capital markets
hoarding is non-existent or, at any rate, not being practiced by intelligent
and informed people, and so it can be safely ignored. However, as a little
thought will show, marginal saving is present even in the most advanced
modern economies. The objects of hoarding are as varied as the means are
ingenious. The latter include inventory padding both at the level of input
and output of production, as well as the deliberate use of leads and lags in
warehousing. It also includes cutbacks in production quotas of marketable
goods (such as crude oil, lumber, gold, etc.) which have been utilized for
the same purpose in recent times with dramatic effect, as well as the slowing
of the movement of goods in the pipelines by distributors. The list of
marketable goods that are both hoardable and
consumable is endless. It includes such items as salt, spices, spirits,
sugar, tea, coffee, fragrances, drugs, etc., not to mention grains, energy
carriers, and metals.
It would be an impossible task to estimate,
however tentatively, the size of existing stores of marketable goods. Even if
such estimates were available, it would be impossible to decide which parts
of these stores were held for impending consumption and which were considered
marginal saving by their owners. The only way to grasp the hoarding habits of
people is through theoretical understanding.
Propensity to
Hoard and the Rate of Interest
The owners of stores of marketable goods
periodically revise their quota of stored values held specifically for
purposes of marginal saving. Various considerations will enter into their
calculations, some of which obviously has to do with conditions prevailing in
the markets where their surpluses can be traded. But there is one general and
overwhelming consideration that invariably enters into their calculations and
may move them to change the size of their hoards, always with the same
signature uniformly for all marketable goods. This is none other than the
height of the market rate of interest. If lower than the floor and falling,
then people tend to increase; and if higher than the ceiling of the natural
range and rising, then they tend to decrease their quota of marketable goods
held for purposes of marginal saving (as distinct from hoards held for
consumption).
The inescapable conclusion is that a
relationship exists between the propensity to hoard and the rate of interest.
If the latter is too high then there is a damping, and if it is too low then
there is a buoyant effect on hoarding. The converse is also true: a change in
the propensity to hoard does directly or indirectly influence the rate of
interest through its effect on the relative prices of marketable goods on the
one hand, and on that of bonds on the other.
Dichotomy False:
Present vs. Future Goods
Part of the difficulty that a comprehensive
theory of interest must face is due to the way the problem has traditionally
been stated. It can be formulated as a question: What happens when a man
with present goods to spare but who is in need of future goods meets another
with future goods to spare but who is in need of present goods? I shall
discard this as an unsuitable basis for the theory of interest. The
bargaining positions of these two men are so different that no fair exchange
can be expected to result from the encounter. Not surprisingly, it has always
been in this context that usury was condemned by both criminal and canon law.
We must look around for a more reasonable basis on which to construct a
theory of interest.
Dichotomy True:
Income vs. Wealth
It has never occurred to philosophers and
moralists nor, for that matter, to most economists, that the nature and the
sources of interest could be better grasped if the problem was presented in
the form of a different question: What happens when a man with income to
spare but who is in need of wealth meets another with wealth to spare but who
is in need of an income? Fair exchange is indeed possible in this case.
Just why the problem of converting income into wealth and wealth into income
is important follows from the fact that man is mortal and he knows it. As he
grows old, his former surplus of mental and physical energy will inevitably
turn into a deficit. If he has failed to accumulate wealth in his prime
years, then his twilight years are likely to be miserable. His needs would
overwhelm his resources. He would lack the means to have the diseases
plaguing him treated. To add insult to injury, he would be wide open to
humiliation. However, if he has wealth, then he will be in control of his
destiny despite his declining strength. He will be in a strong bargaining
position: he can exchange a portion of his wealth for an income that will
keep him in comfort and safety for the rest of his life.
That wealth is not everything becomes clear as
soon as conversion into income is denied to the individual, so vividly
portrayed in the comedy of King Midas and in the tragedy of King Lear. The
importance of such conversions could under certain condition be a matter of
life and death.
Irreducible Form
of Credit
The exchange of a present good for a future
good is not an irreducible form of credit. Nor is a loan from A to B.
These exchanges fall short of capturing the essence of interest. They could
be viewed as the combination of two exchanges. For example, the loan from A
to B is an exchange of the income of B for the wealth of A,
later followed by the return of the wealth to A in exchange for
restoring the income to B. Accordingly, we shall view the exchange of income
and wealth as the irreducible form of credit to which all other credit
transactions can, and must, be reduced. This also has the advantage of
including the conversion (as distinct from exchange) of income into wealth
through hoarding, and wealth into income through dishoarding, as a limiting
case.
Principle of
Capitalizing Income
Whenever provision for deferred consumption is
made, it is done through converting income into wealth as a first step, to be
followed by a second, converting wealth back into income. In this view income
is perishable: 'use it or lose it', and conversion into wealth is the way to
conserve it. The question of optimizing the conversion of income into wealth
and wealth into income arises naturally. The answer can be found in the
agency of credit and exchange. As I have observed already, in traditional
accounts the most primitive form of credit is the exchange of a present good
for a future good. I have discarded this view and replaced it with a more
natural one that can be considered as the irreducible form of credit: the
exchange of income and wealth. This represents a leap in the efficiency of
direct conversion of income into wealth through hoarding, and that of wealth
into income through dishoarding. We shall see that interest appears as the
measure of the efficiency of exchange (as compared with that of direct
conversion).
Exchanging income and wealth is possible
because incomes, although perishable, can in fact be capitalized. As history
and logic suggest, income is primary and wealth is derived (secondary). This
was formulated by the American economist Frank A. Fetter as the Principle of
Capitalizing Incomes. Early on scholastic philosophy recognized the
importance of exchanging income and wealth for the benefit of society. In
1414 at the Council of Constance the principle was upheld that exchanging
income for wealth involved no usury per se. Even earlier, St. Thomas
of Aquinas (1225-1274) declared that a moderate discount on short-term
commercial credit is not usurious and is therefore admissible. He justified
the discount as a risk-premium and a compensation for lost income.
Structure of
Capital Markets
From the point of view of mortal man income
and wealth are distinct categories independent of one another. When he
converts income into wealth, he merely obeys the law of the biosphere
according to which all living things survive by saving their substance. There
is no other way to go through the fat-year/lean-year cycle. In addition, the
economizing individual must provide for his and his spouse's old age, as well
as for the education of his offspring.
We have discarded the idea of exchanging
present goods for future goods as the basic problem of interest, and replaced
it with the irreducible form of credit: exchanging income and wealth. Unlike
the former, the latter arises out of identifiable, immediate, and concrete
human needs, having to do with mortality and the problem of growing old. By
contrast, the concept of exchanging present goods for future goods is barren.
It is not grounded in any immediately identifiable human need. Insofar as it
arises at all it is always in the context of complementing exchanges of
wealth and income. Our innovation of considering the exchange of wealth and
income as basis for the theory of interest will pay rich dividends when we
classify the various types of capital formation, and study the structure of
capital markets.
The Square Model
Featuring the Annuitand, Annuitant, Entrepreneur,
and Inventor
The formation of the rate of interest is
usually explained in terms of a diagonal model of the capital markets
featuring two participants: the supplier and the user of 'loanable funds'.
This model is woefully inadequate as it blots out the time element between
the raising and repayment of the loan and, more fundamentally, the crucial
process of capital formation. It ignores the Principle of Capitalizing
Incomes. Our theory presented in this course will involve a step-by-step
refinement of the diagonal model into a square, a pentagonal and finally a
hexagonal model of the capital markets. The square model has four
participants: the annuitand (the man who is
accumulating capital to support his future annuity), the annuitant (the man
who is already drawing an annuity), the entrepreneur and, finally, the inventor.
They are distinguished by their respective needs that they bring to the
capital market to satisfy as follows. The annuitand
needs to convert income into future wealth; the annuitant needs to convert
wealth into income; the entrepreneur needs wealth in order to convert it into
future income; and the inventor needs income in order to convert it into
future wealth. The square model has the merit of clearly identifying the
ultimate sources of supply and demand for wealth and income.
The four corners of the square represent the annuitand and the inventor plus the annuitant and the
entrepreneur. Two kinds of partnership arise: that of the first pair
represents the formation of R&D (research and development), and that of
the second the formation of entrepreneurial capital. Often these partnerships
are concealed under family bonds. The father is the annuitand
(later, annuitant) and the sons the entrepreneur (or inventor). The family is
the primitive social unit furnishing a framework for capital accumulation (for
exchanging income and wealth).
Notice that there is another way to form
partnerships by pairing the annuitand with the
annuitant, and the entrepreneur with the inventor. The former is a
partnership to supply credit, and the latter is one to utilize it. It is
highly important to note, however, that the bargaining position of the two
partnerships fails to be symmetric. The providers of credit: the annuitand and annuitant do not depend on the exchange in
order to reach their ultimate end, unlike the users of credit: the
entrepreneur and the inventor, who do. Zero interest means the denial of
incentives to proceed with the exchange of income and wealth. Given this
denial, the providers of credit would abstain from the exchange and fall back
on direct conversion. The annuitand would convert
his income into wealth through hoarding; the annuitant would convert his
wealth into income through dishoarding. It would be absurd for the annuitand to exchange his income for less future wealth
than he could himself accumulate through hoarding; and for the annuitant to
exchange his wealth for a smaller income than he could himself generate
through dishoarding. The same is not true for the entrepreneur and the
inventor. In the case of zero interest they are helpless. For them, zero
interest is an un-surmountable obstacle to capital formation. The
entrepreneur's potential income could not be generated in the absence of
entrepreneurial capital. The inventor's potential wealth would not be
realized in the absence of R&D capital. The square model of the capital
market reveals that the exchange of income and wealth is inherently
asymmetric. The annuitand and the annuitant could
still satisfy their need to convert should the exchange fail; the
entrepreneur and the inventor could not. For them it is no exchange - no
conversion. The impaired bargaining power of the latter pair could be
assuaged somewhat by admitting the capitalist as the fifth participant of the
pentagonal model of the capital markets.
The Pentagonal
Model Featuring the Capitalist
The partnership of the entrepreneur and the
inventor is net long of future wealth and net short of present wealth. In
order to make the partnership viable we introduce a fifth participant who is
net long of present wealth and net short of future wealth. He is none other
than the capitalist specializing in the exchange of present wealth for future
wealth. This brings out the importance of the trinity of the entrepreneur,
the inventor, and the capitalist. In the words of Ludwig von Mises, they represent the three most progressive elements
in capitalist society, who benefit the non-progressive majority in every
possible way. The particular combination of talent, brain and will-power
represented by the threesome heralds a new epoch of progress, far beyond the
capabilities of individual talents if employed in isolation.
The Hexagonal
Model Featuring the Investment Banker
A final refinement is the hexagonal model of
the capital markets and the introduction of the sixth and last protagonist of
the drama of capital accumulation: the investment banker. The refinement is
made necessary by the fact that no two annuities are alike. Yet trading them
will still be possible if the differences are bridged over by the gold bond.
The investment banker's function is clearing and brokering. He matches the
varied demands thrown upon the capital market from its other five corners. He
must be prepared to enter into partnership with the annuitand,
annuitant, entrepreneur, inventor, or the capitalist, as the case may be,
through his specialized instruments of annuity and mortgage contracts. At the
same time he will balance his net liability or asset resulting from this
activity through the purchase or sale of the standardized instrument, the
gold bond.
The hexagonal model of the capital market
brings about a great increase in scope for the most successful combination of
capitalist production: the triangle of the entrepreneur, the inventor, and
the capitalist mentioned earlier. 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 does the entrepreneur in finding a
suitable inventor. Neither of them is at the mercy of the capitalist. If the
invention is good and the enterprise is sound, then they could immediately
start production on the most favorable terms
through the good offices of the match-maker, the investment banker. 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 can safely be left to the bond market.
The Concept of
Interest
Interest is an income in perpetuity which
exchanges for the unit of wealth. The rate of interest is measured as a
percentage of the unit of wealth that accrues to the beneficiary of the
income in each one-year period. Thus, if the unit of wealth is one gold
dollar and it exchanges for an income in perpetuity amounting to one gold
cent per quarter, then the rate of interest is four percent per annum. Of
course, an income in perpetuity is an abstraction. The bond is a contract
drawn up for a finite period. It involves two exchanges, with the second to
reverse the first at the same rate of interest, so that the income flow
becomes finite. In earlier times perpetual bonds (called consols
by the British) were also offered to the saving public. Consols
represented interest in its purest form. The British government defaulted on consols before defaulting on bonds, and withdrew the
issue.
The Propensity to
Save and the Rate of Interest
There is a mathematical relation between the
market price of the bond and the rate of interest, called the Bond Equation,
that I shall discuss in a future Lecture. The bond equation makes it possible
to define the rate of interest in terms of the bond price. Thus we must
regard the bond market as the place where the formation of the rate of
interest takes place. The bond equation shows that the rate of interest
varies inversely with the bond price. The reciprocal movement of the two we
can compare to the seesaw: as the rate of interest goes up, the bond price
comes down, and vice versa. This is a mathematical, not a statistical law,
tolerating no exceptions. The seesaw can be paraphrased by saying that the
rate of interest and the propensity to save are in an inverse relationship
with one another: the higher the propensity to save the lower will be the
rate of interest and vice versa. The seesaw plays a fundamental role in our
analysis of the formation of the rate of interest.
It is important that only gold bonds may enter
these considerations. A bond payable at maturity in irredeemable currency is
a promise that is fulfilled by making another irredeemable promise. In
effect, it is a promise to defraud in exactly the same way as the promise of
Charles Ponzi to pay interest at the rate of 100 percent per annum has been. No
serious student of interest can take such bonds for anything but a cruel joke
on the public. The Criminal Code calls for severe punishment for deliberately
defrauding the public through confidence games and Ponzi-schemes. The
issuance of irredeemable promises to pay, be it interest-bearing such as a
bond or non-interest bearing such as a bank note, fully exhausts the concept
of fraud. Governments have interfered with the justice system by blocking
citizens and creditors who wanted to sue it in court. Not only are injured
parties denied justice, they are also denied a public hearing of their case.
Worse still, irredeemable currency violates the monetary provisions of the
American Constitution. We are witnessing the shameful corruption of the
justice system and trampling on the Constitution. For this not only the
politicians but also jurors and legal scholars must share the responsibility.
The day of reckoning will come when the economic system based on the house of
cards of irredeemable currency will collapse causing the people to suffer
excruciating economic pain.
The Gold Standard
as the Stabilizer of the Economy
One of the cardinal points about the gold
standard as it is remembered today is that it was an attempt to stabilize the
price level -- an attempt that has failed. But it would be closer to the
truth if the gold standard were remembered as an attempt to stabilize the
interest rate structure -- an attempt that has succeeded. While interest
rates had their ups and downs as part of the long-wave economic cycle under
the 19th century gold standard, these undulations were minuscule in
comparison to the wild gyrations displayed after the link between currencies
and gold was severed in the fourth quarter of the 20th century.
Stabilization of prices is neither possible
nor desirable. Price changes are part of the signaling
mechanism of the economic system that regulates both production and
consumption. By contrast, the stabilization of interest rates is both
possible and desirable. Unstable interest rates lead to general economic
instability, including that of prices, production, saving, and investment --
all to the detriment of economic welfare. At worst, they could trigger
uncontrollable resonance between commodity prices and interest rates. That
would create a runaway vibrator, bringing about economic collapse in the form
of hyperinflation (with the economy succumbing to infinite interest) or
deflation (with the economy succumbing to zero interest).
The stabilization of interest rates would
benefit everybody. It was a tragic mistake to discard gold from the monetary
system in complete disregard for the damage it would do to the stability of
the interest rate structure. The extreme volatility of interest rates has
been plaguing the world economy since 1971. In spite of
appearances, current low rates don't spell stability. They are the quiet just
before the approaching storm.
Disequilibrium
Theory of Price Formation
I conclude this Lecture with a preview of the
follow-up course Monetary Economics 202 on the formation of the rate of
interest. Carl Menger revolutionized economics by
throwing out the equilibrium theory of price formation to replace it with a
disequilibrium theory. He observed that the market quotes not one but two
prices, a higher asked price and a lower bid price. Transactions may take
place anywhere within the range determined by these two. We have to study two
independent market processes, one responsible for the formation of the asked
price, and another for that of the bid price. It turns out the asked price is
the outcome of the competition of the consumers, while the bid price has to
do with that of the producers.
Competition takes the form of arbitrage. Being
the combination of a sale and a purchase, arbitrage is the most comprehensive
form of human action. The market price is not the result of supply/demand
equilibrium, but the outcome of a convergence process whereby it is confined
to an ever-narrowing range determined by the vanishing spread.
Disequilibrium, or a lower state of coordination is being replaced by a
higher one which, however, still reflects disequilibrium and calls for
further adjustments. The disequilibrium theory of price formation is superior
to the equilibrium theory as it does away with the spurious notions of supply
and demand. It reflects reality more closely. It shows that the price is not
a state but, rather, the outcome of a convergence process.
In more detail, the asked price is formed
through the horizontal arbitrage of the marginal consumer, and the bid price
is formed by the vertical arbitrage of the marginal producer. The marginal
consumer is the first to refuse to buy the uptick in price, and horizontal
arbitrage means that he is ready to buy a cheaper substitute. The marginal
producer is the first to refuse to sell the downtick in price, and vertical
arbitrage means that he is ready to buy cheaper substitutes for the producer
goods at his input. We see that the asked price is determined by marginal
utility. It can be characterized as the lowest price at which consumers can
buy as much as they want without haggling -- explaining how the asked price
earns its name. The bid price is determined by marginal profitability. It can
be characterized as the highest price at which producers can sell all they
have without haggling -- explaining how the bid price earns its name. The
spread between the asked and bid prices is closed by the arbitrage of the
market makers. To recapitulate:
The asked price of a consumer good marks the
point where the opportunity cost of buying an additional unit becomes
critical to the marginal consumer. He is the first to refuse to buy the
uptick, in view of his opportunity to buy a substitute.
The bid price of a consumer good marks the
point where the opportunity cost of selling an additional unit becomes
critical to the marginal producer. He is the first to refuse to sell the
downtick, in view of his opportunity to substitute a new producer good at his
input.
Disequilibrium
Theory of the Formation of the Interest Rate
The rate of interest, no less than prices, is
a market phenomenon. Once again we find ourselves in disagreement with Ludwig
von Mises. He postulated in Human Action
that "the loan market does not determine the rate of interest, but
adjusts it to the rate of originary interest as
manifested in the discount of future goods" (op.cit.,
p 527). For us, the formation of the rate of interest is the result of a
market process, analogous in every detail to that responsible for the
formation of prices.
Our starting point is the observation that the
bond market also quotes two prices, the higher asked and the lower bid price
for bonds. In view of the seesaw, the asked price corresponds to the floor,
and the bid price to the ceiling, of the range to which the rate of interest
is confined. Bonds may change hands anywhere within the range determined by
the asked and bid price. We have to study two independent market processes:
one responsible for the formation of the asked price for bonds (or the floor
for the rate of interest), and the other responsible for that of the bid
price (or the ceiling for the rate of interest). It turns out that the former
is the outcome of the competition of bondholders, while the latter is the
outcome of the competition of entrepreneurs.
Competition takes the form of arbitrage.
Bondholders engage in arbitrage between the bond market and the gold market;
and entrepreneurs between the bond market and the stock market. In more
details, the asked price for the bond is formed by the horizontal arbitrage
of the bondholders, and the bid price by the vertical arbitrage of
entrepreneurs. Bondholders won't let the bond price go sky high. They will
take profit in selling the bond and stay invested in gold until bond prices
come back to earth. Entrepreneurs won't let the bond price to keep falling
forever. They will step in and buy the bond out of the proceeds of selling
their stock. Thus the floor for the rate of interest is determined by
marginal time preference. It can be characterized as the highest rate of
interest which savers still refuse to accept. The ceiling for the rate of
interest is determined by the marginal productivity of capital. It can be
characterized as the lowest rate of return on capital that entrepreneurs will
still accept before they go out of production and invest the proceeds from
the sale of their capital goods in bonds. The spread between the floor and
ceiling is closed by the arbitrage of the market makers in bonds. To
recapitulate:
The floor for the rate of interest marks the
point where the opportunity cost of holding the bond becomes critical to the
marginal bondholder. He is the first to sell his bond upon the next downtick
in the rate of interest, in view of his opportunity to carry his savings in
the form of a present good, gold, instead of a future good, the bond.
The ceiling for the rate of interest marks the
point where the opportunity cost of owning capital goods becomes critical to
the marginal entrepreneur. He is the first to buy the bond upon the next
uptick in the rate of interest, in view of his opportunity to sell his stocks
and carry earning assets in the form of bonds rather than capital goods.
I urge my audience not to get discouraged if
this material appears to be too concentrated to digest at once. After all,
this is a synopsis of a future course, Monetary Economics 202: The Bond
Market and the Formation of the Rate of Interest. We shall treat this
subject in much greater details in future Lectures.
A Tale of Two
Schools
Our new theory of interest can be described as
a synthesis between two well-established schools: the time preference and the
productivity school of interest. They are competing, antithetical schools,
and a fratricidal war between their adherents has long retarded theoretical
progress.
According to the time preference theory of
interest a time premium exists, and is incorporated in the price of present
goods over that of future goods. This time premium is a category of human
thought in much the same way as our concepts of space and time are, and it exists
independently (and even in the absence) of production. By contrast, the
productivity theory of interest insists that it is the marginal productivity
of capital that determines the height of the rate of interest, regardless
whether capital is provided by nature or by savings. On the face of it
irreconcilable antagonism exists between the two positions. Yet a synthesis
between the two opposing schools is possible, as our disequilibrium theory of
the formation of the interest rate shows.
The Gold Coin and
the Rate of Interest
To conclude, gold furnishes the mechanism
whereby savers could have input in the formation of interest. If dissatisfied
because rates were too low, they could force the banks to take their marginal
time preference into consideration. The mechanism had teeth. Gold hoarding
was effective. Not only was it a symbolic protest vote against credit
policies suppressing the rate of interest to unreasonably low levels; it did
bring about the desired changes. Since gold coins served as bank reserves
under the gold standard, by withdrawing their deposits and converting their
notes into gold coins savers could force the banks to contract outstanding
credit. Moreover, a continuing squeeze on bank reserves could not help but
alert legislators that people were unhappy with profligate government
spending financed through the banking system. They could amend their ways by
eliminating wasteful spending. The system of checks and balances worked well
during the first 150 years of the American Republic. Not government
bureaucrats but the saving public regulated the rate of interest. Regulation
was for the benefit of everybody, not just for the benefit of a small
minority, however influential. The tool of this regulation was the gold coin.
It is not surprising that the gold standard
was unpopular with governments, for it has been a fetter on buying votes
through public spending. Governments couldn't perpetuate their power by
promising pie in the sky. Frugality was a virtue and profligacy a vice,
especially when it came to the public purse. The electorate could express its
displeasure with government spending and throw profligate governments out of
power. Not only did it have the ballot paper, the electorate also had the
gold coin with which to vote. And vote it did, on every business day. If it
did not like the credit policies of the banks and the government the whip,
gold hoarding, was at hand. It was not only the politicians with whom the
gold standard was unpopular. Economists did not like the gold standard either.
They looked at it as you would at a naughty child who blurts out embarrassing
truths.
The first attack on the gold standard came
from the British economist David Ricardo (1772-1823). In 1819 he proposed his
'bullion plan' according to which gold coins should be withdrawn from
circulation. Gold should be held by banks in bullion form for the purpose of
redeeming notes and deposits, the required minimum being the standard gold
bar of 400 oz,
or approx.12.5kg . Clearly, this plan was designed to short- circuit gold's
role in the regulation of the rate of interest. The marginal bondholder would
be frustrated whenever he wanted to protest the artificially low rate of
interest. Of course, he could sell his bond, but in doing so he would be
jumping from the frying pan into the fire. He would have to hold bank notes,
so that he would get zero interest in place of the low rate of interest he
wanted to protest. The marginal bondholder was denied the gold coin he would
need in order to make his protest effective.
Interest under
the Regime of Irredeemable Currency
The synthesis between the time preference and
the productivity theory of interest assumes that there is no government
interference in credit relations. Our theory of interest is only a first
approximation to the problem, as it is valid only under the regime of the
gold standard. However, it can be extended to the regime of irredeemable
currency which is characterized by massive intervention of the government and
its central bank in the credit markets.
Since time immemorial governments have been
predisposed to intervene on behalf of the debtors and to the prejudice of the
creditors. There may have been ideological motivation for this, but it is
more likely that governments were pursuing self-serving policies. They were
debtors themselves. They wanted easy money in order to aggrandize and
perpetuate their own power. They have done all they could to compromise the
sovereignty of the saver. Through various measures such as fomenting credit
expansion or inflation, and through obstructing the free flow of gold, they
have tried to undercut the importance of saving and to promote the cause of
spending. The regime of irredeemable currency must be seen as the fulfillment of those early aspirations.
The Ratchet and
the Linkage
Recall that when access to gold is inhibited
or denied, as it has been with increasing frequency and intensity throughout
the entire history of the gold standard, gold hoarding is superseded with
similarly increasing frequency and intensity by the hoarding of marketable
commodities. People would increase their marginal savings. This hoarding can
also be characterized as 'inventory inflation' financed through the
liquidation of bond holdings in response to artificially low interest rates.
As I have pointed out, hoarding bank notes would be counter-productive. It
would be practiced by simpletons only.
My notion of inflationary and deflationary
spirals is very different from that of mainstream economics. It goes back to
the Swedish economist Knut Wicksell (1851- 1926).
The initial impetus of credit expansion pushes the market rate of interest
below that of marginal time preference, making the propensity to hoard
increase. It triggers a first round of purchases of marketable goods for
hoarding purposes with the proceeds from the sale of bonds. Marginal savings
grow. While selling pressure on bonds increases interest rates, buying
pressure on goods increases the price level. The higher price level will
increase marginal time preference. When prices are expected to rise, the
marginal saver will demand compensation in the form of higher interest rates.
The net result is that, once again, the market rate of interest is below the
rate of marginal time preference, and the propensity to hoard increases.
This will trigger a second round of purchases
of marketable goods for hoarding purposes financed through further
liquidation of bond holdings. The inflationary spiral repeats itself at a
higher level of prices and interest rates. Thus a ratchet is engaged whereby
subsequent rounds of increases in marginal savings pushes commodity prices as
well as the rate of interest to ever higher levels. It may take decades for
the inflationary spiral run its course. It is not possible to predict when
the spiral will turn around. At any rate, high and increasing prices coupled
with high and increasing interest rates will eventually lead to panic. People
realize that further increases in the rate of interest would threaten the
value of their marginal savings. Liquidation of marginal hoards of marketable
goods begins. This spells a deflationary spiral, to which the inflationary
spiral gives way, featuring ever lower propensity to hoard, or inventory
deflation. There is a drawn-out process of dissipating excessive stockpiles..
The collapse in demand for newly produced goods causes business lethargy, as
reflected by falling interest rates along with falling prices. It may take
decades before business confidence can be rebuilt and economic expansion
resumed, signaling the end of the deflationary
spiral. It goes without saying that credit expansion will spark a new round
of the cycle before long, and the process will go on and on. This, then, is
the long-wave inflation/deflation cycle, also known as the Kondratyeff cycle.
Note that the ratchet-effect is also
responsible for the linkage between the movement of the rate of interest and
that of the price level. With due allowance for leads and lags, the price
level and the interest-rate structure are linked, and must move in the same
direction. Linkage has been noted by several economists, but reasoning in
terms of linear models (such as that of the quantity theory of money) has
failed to provide an explanation of the phenomenon. Only partial explanations
have been given, so that linkage is still something of a mystery. My
explanation is in terms of a non-linear model. An increase in the propensity
to hoard induces a long-term money-flow from the bond market to the commodity
market, ultimately leading to panic, turning the money-flow back. Thus we
have an oscillating money-flow between the bond market and the commodity
market which was caused in the first place by the government in sabotaging
and finally destroying the gold standard.
The linkage represents economic resonance
between the price level and the rate of interest. The danger is that this
resonance may cause amplitudes to increase without limit. Just as in physics,
resonance could cause runaway vibration culminating in the self- destruction
of the system. In economics, self-destruction is realized by hyperinflation
(that may be described as the blackhole of infinite
interest), or deflation (the blackhole of zero
interest).
Note how the natural stability of the economic
edifice has been perverted by the removal of gold. Hoarding makes for stability
under the gold standard, as it is self- limiting through the interest-rate
mechanism. But when gold is removed from the system, or when its free flow is
inhibited by the governments, hoarding becomes cumulative, as a ratchet sends
both the price level and the rate of interest ever higher which continues
until panic puts an end to it. At that time a slow and painful process of
dishoarding starts that will send the price level as well as the interest
rate structure spiraling downwards. Each repetition
of the cycle brings higher amplitudes in its wake for both the price level
and the rate of interest, higher than those of the previous one. As the
interest-rate cycle resonates with the price-level cycle, a runaway vibrator
is activated.
Between Scylla
and Charybdis
The long-wave inflation/deflation cycle is
aggravated rather than alleviated by central bank intervention. Directly or
indirectly, contra-cyclical monetary policy amplifies the oscillating
money-flow back-and-forth between the bond market and the commodity market.
An accurate reading of the present situation is that after the inflationary
spiral lasting for forty years, culminating in the 1980 price explosion, the
world economy saw a panic ushering in the deflationary spiral that still continues.
Prices and interest rates peaked in 1980 when dishoarding started. It is true
that the downward ratchet of the interest-rate structure is more obvious than
that of the price level, but you would be well- advised to watch for a very
painful erosion of prices and profits as firms keep losing their
pricing-power. Central bank intervention is counter-productive. As it tries
to 'reflate' by injecting new cash into the economy, the central bank will
only pour oil on the fire. Whenever it wants to inject new cash, the central
bank goes to the bond market to buy bonds. But in doing so it will only join
the crowd of frenzied bond speculators already busy in bidding up bond prices
and pushing down interest rates as part of the deflationary process. As a
matter of fact, speculators have taken it for granted that the central bank
will act that way thereby taking the risk out of bond speculation. The new
money injected in the economy, which the government has hoped that it would
flow to the commodity market and bid up prices there, does instead flow to
the bond market where the fun is. It stokes the fires of the boom there
pushing interest rates further down and, due to the linkage, it makes prices
fall as well. Far from putting an end to the deflationary spiral, central
bank action depresses the economy even more. Unless, of course, the deluge of
new money injected in the economy scared bond speculators in causing them to
cut and run. As they dumped their bonds, they would make bond prices, and the
value of irredeemable currency, collapse.
There is not enough room between the Scylla of
inflation and the Charybdis of deflation to squeeze through. Before the
central bank can navigate the economy to safety, further slimming appears
necessary.
References
Ludwig von Mises, Human
Action, Third Edition, Chicago: Henry Regnery,
1966.
Antal E. Fekete, Whither
Gold, and Other Collected Essays, Hammond, Louisiana: Ededge
(www.ededge.com), 2002.
Antal E. Fekete, The Central
Banker As the Quartermaster-General of Deflation, www.goldisfreedom.com, January, 2003.
January 1, 2003
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 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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