Articles:Editorial, News, Clearly Declining Marginal Utility of Additional Debt, How do we get there??, Theory of Interest and Prices in Paper Currency Part V (Falling Cycle), The American Corner: Gold Confiscation
In Part III (http://keithweinereconomics.com/2013/06/16/theory-of-interest-and-prices-in-paper-currency-part-iii-credit/), we looked at how credit comes into existence via arbitrage with legitimate entrepreneur borrowers. We also looked at the counterfeit credit of the central banks, which is not arbitrage. We introduced the concept of speculation in markets for government promises, compared to legitimate trading of commodities. We also discussed the prerequisite concepts of Marginal time preference and marginal productivity, and resonance.
In Part IV (http://keithweinereconomics.com/2013/07/16/theory-of-interest-and-prices-in-paper-currency-part-iv-rising-cycle/), we discussed the rising cycle. The central planners push the rate of interest down, below the marginal time preference and unleash a storm whose ferocious dynamics are more than they bargained for. The hapless subjects of the regime have little recourse but they do have one seeming way out. They can buy commodities. The cycle is a positive feedback loop of rising prices and rising interest rates. Ironically, their clumsy attempt to get lower interest results in rising interest. Alas, the cycle eventually ends. The interest rate and inventory hoards have reached the point where no one can issue no bonds or increase their hoards.
In this Part V, we discuss the end of the rising cycle and the start of the falling cycle. We examine its dynamics and its mode of capital destruction. Lastly we look at the response of the central bank.
It is not possible to pay debts with inventories of completed or partially completed product, nor even with raw commodities. In order to circulate as money, a good must have an extremely narrow bid-ask spread. Commodities have a wide spread, especially in the environment of the late stages of the rising cycle. Liquidations are pushing the bid down. The ask side is still being pushed up, by those businesses which are still buying. Work in progress of course could not be sold, except to another company in the same industry.
Recall that the rising cycle is driven by selling bonds to build inventories. This creates a conflict: the desire to accumulate more inventories because prices are rising rapidly vs. the need for cash to service the debt. In any conflict between want and need, between speculation and leverage, the latter must win in the end. At the same time that the marginal utility of the unit of hoarded goods is falling, the amount owed is rising.
The backdrop is layoffs and liquidations, as each time a company’s capital and plant must be renewed, it is harder and harder to make a business case. If it is profitable to borrow at 7% to buy machines to manufacture cameras, it may not be profitable at 14%. So factories are closed, resulting in liquidations. People lose their jobs, resulting in increasing softness in the consumer bid for goods.
Eventually, as it must, the trend comes to its ignominious end. The interest rate spikes up one final step higher as banks are taking capital losses and become even more reluctant (or able) to lend. The rate of interest is now, finally, above marginal time preference. That spread is reverted to normalcy. Unfortunately, the other spread discussed in Part III inverts.
That other spread is marginal productivity to the rate of interest; the latter is now above the former. I mentioned in Part IV that many people credit Paul Volcker for “breaking the back of inflation” in 1981. The central planners cannot change the primary trend, and in any case the problem was not caused by the quantity of money, so the solution could not have been reducing the money supply. At best, if he pushed up the rate of interest he accentuated the trend and helped get to the absolute top. The 10-year Treasury bond traded at a yield around 16%.
The rising cycle was driven by rising time preference that caused rising interest as businesses borrowed to finance inventories which caused time preference to rise further. During this process, at first one by one and then two by two, enterprises were forced to close and liquidate their inventories, as their businesses could not earn the cost of capital. This force opposed the rising cycle.
Now it fuels the falling cycle. The only good thing to be said is that interest rates are not rising and therefore viable companies are not squeezed out due to rising cost of capital. The wrecking ball of rising rates has finished on that side of the street. It is done destroying capital by rendering it sub-marginal, when it cannot produce enough to justify borrowing at the higher rate of interest.
As we shall see, that wrecking ball will not repair the damage it has done when it swings to the other side. A falling rate destroys capital also, though by a different mechanism. It causes the Net Present Value (NPV) of every bond to rise. This is because the NPV of a stream of future payments is calculated by discounting each future payment by the interest rate. The lower the interest, the lower the discount for all future payments. This is why the bond price rises.
Falling interest rates benefit one group. The bond speculators get rich. They can buy bonds, wait a little while, and sell them for a profit. The bond bull market starts off slowly but becomes ferocious over time. In nature, if a source of readily usable energy exists then a specialized organism will evolve to exploit it and feed off it. This is true for plants and animals in every niche on dry land, and it is for strange sea creatures near volcanic vents on the icy sea floor. Plants convert sunlight into sugars and animals eat plants, etc. The same is true for free profits being offered in the bond market. A whole parasitic class develops to feed off the free capital being offered there.
Savers and pension funds cannot profit from falling rates because they hold until maturity. The more the interest rate falls, the more they are harmed. The lack of savings is another blow to the economy, as it is savings that is the prerequisite to investment and investment is the prerequisite to jobs and rising wages.
By contrast, the speculators are not in the game for the interest payments. They are in for capital gains.
Where does their free profit come from? It comes from the capital accounts—from the balance sheets—of bond issuers. Anyone who has sold a bond or borrowed money with a fixed-rate loan should mark up the liability, to market value. I have written previously on the topic of falling interest rates and the destruction of capital.
On the way up, businesses could seemingly dictate whatever prices they felt like charging. Recall my example of cans of tuna fish in the 1970’s; stores were re-stickering them with higher prices even in the short time they sat on the shelves. My theory predicts that gross margins must have been rising everywhere, especially if companies managed their inventory to move from input to final sales over a long period of time (this would be worth researching in further papers).
But today, they have not this power. Even in industries where prices have been rising, the consumer is reluctant and sluggish to pay and there are many competing alternatives. In other industries (recall my example of Levis jeans, which applies to clothing in general) there seems to be no pricing power. Many stores in the mall have permanent signs offering big discounts; I regularly see 60% off.
What is it about rising interest rates that allows for aggressively expanding prices and margins, and falling rates that compresses margins and prices?
We said in Part III:
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.
As the interest rate ticks upwards, every producer in every business must adapt his business model to the higher cost of capital. They must earn a higher gross margin, in order to pay the higher interest rate. Higher rates must necessarily drive higher gross margins. We have discussed two ways to get a higher margin: (1) a long lag between purchase of inputs and sale of outputs and (2) higher prices. Strategy #1 is the reaction to the inverted interest to time preference spread. Strategy #2 is the reaction to higher interest rates and thinning competition.
The burden of debt is falling when the interest rate is rising, and we can see it in the reduced competitive pressures on margins. Of course, we are now in the falling cycle and the opposite applies. If one wants to track the “money supply”, one can think of the money going, not into consumer goods or commodities, but into productive capacity. I propose that one should think of inflation not in terms of the “money supply” but in terms of counterfeit credit. In the rising cycle, counterfeit credit is going into commodities. In the falling cycle, by contrast, it is going into bonds that finance government and also productive capacity.
I call it a “ferocious” bull market in bonds because it is gobbling up the capital of businesses who borrow (and they have to borrow in order to keep up with their competitors). The competition is ferocious, because each new business can borrow at lower rates than incumbent competitors. The new entrant has a permanent competitive advantage over the old. Then the rate falls further and the next new entrant enters. The previous new entrant is now squeezed, doubly so because unemployment is rising. The prior incumbent is wiped out, its workforce is laid off, and its plant and inventory is sold off. Unemployed workers are not able to aggressively bid up prices. There is, by the way, another reason why falling rates cause unemployment. There is always a trade-off between capital invested to save labor vs. employing labor. At lower cost of borrowing money, the balance tilts more heavily in favor of investment.
In the falling cycle, a vicious one-two punch is delivered to productive enterprises. Low margins make it necessary, and low interest makes it possible, to use big leverage relative to its equity. There is a term for a company with low and shrinking margins and high leverage.
If you have ever owned one of those impossibly delicate glass figurines with long tendrily tails, whiskers, manes, and tongues, you know that the slightest bump causes it to break. The same is true for many businesses in the falling cycle. In any case, it is only a matter of a sufficient drop in the interest rate for many to be wiped out.
Opposite to Fekete’s Dilemma, the problem now is that the cheaper one finds the cost of borrowing, the more meager are the opportunities to profit combined with the higher the price of capital goods.
The falling cycle is a cycle of capital churn. Perfectly good capital is wiped out by the dropping interest rate, which gives incentive to a new entrepreneur to borrow to build what is essentially a replacement for the old capital. And then his capital is replaced by churn, and so on.
So long as the interest rate remains above marginal productivity (and marginal time preference), people choose to buy the bond over buying commodities. The burden of debt is rising. As Irving Fisher wrote in 1933, “…the more debtors pay, the more they owe.” It is better to be a creditor than a debtor (until the debtor defaults).
Businesses, struggling under this burden, do everything possible to squeeze inventory and fixed capital out of their businesses, and buy back some of their debt. This adds more oil to the fire of rising bond prices and falling interest rates. It is no coincidence that Lean, the Toyota Way, began to be widely adopted in the 1980’s. It was not well suited to the rising cycle of the post WWII era, but it was demanded by the falling cycle after Volcker.
Meanwhile, the central bank is not idle. What does every central bank in the world say today? They are fighting the monster of “deflation”. How? They want to increase the money supply. How? They buy bonds.
The bond bull market is ferocious indeed.
The last falling cycle ended just after World War II. The situation today is unlike that of 1947. One key difference is that credit expansion to fuel the falling cycle was limited by the ties to gold that were still partially in place after FDR’s 1933 gold confiscation and kept in place in the Bretton Woods Treaty in 1944. Today, there is no such constraint and so the end of the falling cycle will be quite different, as we explore in Part VI.
If you have read my last three articles, you are starting to understand the true value of Honest Money to society and to you and ME… but we have barely scratched the surface. The well hidden ‘magic’ of Gold money emerges only once Gold is in free circulation.
However, we do have a slight problem… namely, how in heck do we transition from a paper world, in hock up to its ears, to a world of honest money… to a world of modest, honest debt… to a world where power lies with the people, not with banksters and G’men?
A tough question indeed… and another place where a Big Lie sneaks in… like ‘there is no way’ to go ‘back on Gold’… so don’t even try. If we believe this lie, we are damned to continue with the Chinese paper torture… and nature will take its own course… we will be dragged kicking and screaming back to honest money. Better we disbelieve the Big Lie, and find a rational, reasonable way out of our paper dilemma. I quote Hans Sennholz, well known Austrian economist;
“Sound money and free banking are not impossible, they are merely illegal. That is why money must be deregulated. The Gold standard will return as soon as people realize that honesty is the best policy.
As hope of ill gain is the beginning of the fiat standard, so is honesty the mother of the Gold standard. The Gold standard is as old as civilization. Throughout the ages, the Gold standard has emerged again and again because man needed a dependable medium of exchange.”
To find our way back, we must understand that a Gold Standard has more than one component; sure honest, real money, Gold and Silver, must be in circulation and in the hands of the people; but this is just the foundation. Once the stable, earthquake resistant Golden foundation is built, we must then build the rest of the edifice.
To create the Unadulterated Gold Standard that is our ultimate goal, we need to build an honest credit system. Credit breaks down into two distinct components; credit (in the form of debt) created by borrowing, and commercial credit, created by clearing urgently needed consumer goods… credit created without borrowing.
The idea of credit and debt are well understood… indeed too well! All the trillions of debt in existence today reflect this emphasis on borrowing… the very stuff we use as ‘money’, the Dollar bills, the Euros… all paper… are borrowed into existence.
Unfortunately, the other vital component, credit created WITHOUT borrowing, is pretty much unknown. I will be writing another article on this very issue… the third leg of the Gold Standard. The first leg is Gold (and Silver) in circulation. The second leg is Gold-bonded debt; the third leg is commercial credit created by clearing, not borrowing.
For now, we talk about Gold Bonds… the second component of the Unadulterated Gold Standard. Gold bonds will work to absorb and extinguish the enormous debt tower that is presently tottering, and threatening to take the world economy down with it. The situation here is simple; ‘if you have dug yourself into a deep hole, first stop digging’.
Even a child knows the truth of this; yet seemingly our ‘fearless leaders’ have no clue… the hole dug so far is approximately sixteen trillion Dollars deep… and instead of stopping the digging, they are encouraging, indeed forcing us to Dig Deeper! What total insanity is this?
We can stop the digging by turning to Gold and Silver as our currency… no more borrowing endless quantities of paper into existence. Then, once we have stopped digging, once we have stabilized the situation, we can think of how to repair the problem… how to fill up that sixteen trillion Dollar hole.
The thought of filling this hole is daunting; it is bigger than the Grand Canyon, and will take an awful lot of filling to heal… but given a stable situation, that is no more digging, even a slow and methodical method will eventually fill the hole; instead of digging, start filling.
Bit by bit, day by day, the wound can be healed… and the economic situation also improve day by day instead of staggering from crisis to ever deeper crisis. After all, it took more than a century of digging to make the debt hole as big as it is… don’t expect to fill it overnight.
So how do we start? The plan is simple… start to issue Gold Bonds, instead of paper bonds. Gold bonds are the second major component of a Gold Standard; Gold Bonds are denominated in Gold units, are payable in Gold units at maturity, and pay interest in Gold units… actual, physical Gold, not paper promises.
The key difference between current bonds and Gold bonds is that no paper is involved… only physical Gold. This means that once a Gold Bond is paid, the debt it represents is extinguished… whereas this is not true of paper bonds. Paper bonds issued by the Treasury are never paid off, cannot be paid off… else the Dollars they ‘back’ are themselves extinguished.
Simply put, by issuing Gold bonds we separate money (Gold coin) from debt… (Gold bond). Once this is done, once Gold bonds are issued, the holders of paper bonds will face a choice; continue to hold paper bonds that mature into worthless paper currency… if they ever mature at all… or trade their paper bonds for Gold Bonds, bonds that not only mature into Gold… but pay interest in the form of Gold.
The choice will be a no brainer… and paper bonds will be gradually replaced by Gold bonds. The Gold bonds will eventually mature, and the debt they represent will be extinguished. Gold income, needed to pay interest on the Gold bond, is assured by the circulation of Gold coin.
As paper bonds are retired, the deep hole will continue to be filled… and financial sanity will return to the planet. It may take years if not decades to make this transition… but that is incomparably better than an outright debt default… see Greece or Cyprus for examples of the destruction caused by default. Imagine a default by a major nation, rather than economically invisible entities like Greece or Cyprus.
The idea of ‘inflating away’ the debt is another Big Lie; not only is inflation just as destructive as an outright default, inflating the debt away is actually impossible. The idea that inflation is the consequence of ‘more money chasing less goods’ is false.
In order to create more ‘money’ to chase the goods, more debt must be created to back the new ‘money’… indeed, for every new Dollar created, new debt of exactly one Dollar must also be created. On the other hand, no debt new or old is needed for Gold; Gold IS money, Gold stands on its own, Gold is not ‘backed’ by anything.
Let’s get started. The sooner we stop digging and start filling the better. If we don’t stop soon, the tower of debt will indubitably collapse, and take the world economy… and you and ‘ME’ with it.
Is Gold, and a ‘Gold Standard’ really for the benefit of the rich… or is Gold and a Gold Standard actually of benefit to the average person? The short answer is; remember the Golden Rule… no, not the Golden Rule that says ‘Do onto others as you wish others do onto you’… but the other Golden Rule, the one that says ‘He Who Has the Gold Makes the Rules’.
Today, the American G’man and his top bankster boast over 8,000 Tons of Gold in their vaults. The German bankster has over 3,000 tons, the Italian near 3,000 T… and on and on. The final numbers are a bit vague, but the world’s central banksters collectively ‘own’… or hoard, or control or whatever you want to call it… tens of thousands of tons of Gold.
In the meantime, average people have almost no Gold… the world population is estimated to hold less than ½ OZ per capita… and the total amount of Gold in (legal) circulation is Zero. Guess who makes the rules?
One example of ‘making rules’ is setting the rate of interest. Mr. Bankster has decreed that he will set a ‘ZIRP’ policy… that is, a Zero Interest Rate Policy… supposedly to ‘stimulate the economy’… and to bring about ‘full employment’. By the expedient of buying bonds with newly created Fiat paper, Mr. Bankster keeps the price of bonds artificially, fraudulently high… which is the same as keeping interest rates artificially, fraudulently low.
Explaining exactly how and why high bond prices equal low interest rates is beyond the scope of this article. If you are interested, Google ‘bond equation’ and you will see the answer for yourself.
Getting on with it, the claim that ‘low interest rates stimulate the economy’ is a Big Lie. Really? Let’s ask our average persons; like our retired couples who live off their life’s savings… does ZIRP benefit their ‘economy’…? With their hard earned cash bringing a miniscule income, far less than the ongoing destruction of purchasing power… so called ‘inflation’… having to live off their rapidly disappearing capital… ZIRP is hardly of benefit to them, is it?
How about our middle aged couples, saving to pay for their children’s education… does ZIRP help their economy? With their savings earning negative real income, with their accumulated wealth being robbed by monetary depreciation… when prices grow far faster than whatever their savings earn… and their wages never even match the rate of monetary depreciation? Hardly. ZIRP is destroying their ‘economy’ as well.
But surely, the young graduate about to embark on his career, who has borrowed a bunch of money to pay for his education… surely HE must benefit? What? He says “no, man… I borrowed a bunch of money for my schooling, and I can’t possibly pay the loan back. I am doomed to live as a debt slave…
I can’t get a job in my field of studies… the best I can do is flip hamburgers part time for a pittance. I am not even allowed to declare bankruptcy… I am Doomed.”
But didn’t Mr. Bankster tell us that he was introducing a ZIRP to ‘stimulate the economy’? If this were true, if the economy were really ‘stimulated’, how come our new grad can’t find a job? If even he doesn’t benefit, then who does? Maybe a businessman? That is another claim by the G’man. That the ZIRP will stimulate business investment, by making ‘money cheap’… and surely more business investment will reduce unemployment? Just another Big Lie, I am afraid.
I ran a business, manufacturing metal forming machinery in Canada, for over thirty years… still run the business in fact, but now the work is all being done in China… and the prevailing rate of interest never had a noticeable effect on our business. The only thing that moved our business, either up or down, was demand for our products.
Demand depends on the financial health of our customers, and of the economy. If ZIRP impoverishes most people, it does not do anything but destroy the economy… and this destruction takes most business with it. Believe me, I know… ZIRP took my business into bankruptcy!
Does anyone benefit from ZIRP… fraudulently low interest rates? Come on, it’s obvious… big time debtors benefit big time. Can you guess who is the biggest ‘big time’ debtor of all? Why, surprise surprise… it’s the G’man. Uncle Sam owes… wait, I will check usdebtclock.org… geez, hard to read, the numbers keep flashing higher and higher… every second the G’man’s debt grows…but as I write this, the official US debt is over $16,800,000,000.
Savor that number for a second or two; it is beyond astronomical… 16 trillion, 800 billion Dollars. Mind numbing. No human mind can imagine even a trillion, never mind multiple trillions… but there it is. The truth is out; Uncle Sam can’t afford higher interest rates, so he tells his bedfellow bankster to push interest rates down… regardless of the economic destruction this causes. This is the true reason behind ZIRP… ignore the Big Lie… and just follow the money; Cui Bono… to whose benefit… The G’man is the big beneficiary of ZIRP.
Thus dies the Fiat world economy… but a Gold Standard economy goes in exactly the other direction; not towards death, but towards prosperity. Remember the Golden Rule; he who has the Gold makes the Rules…
During the nineteenth century, the heyday of the Classical Gold Standard… and of the British Empire… England ruled nearly 85 percent of the ‘civilized’ world… and the Bank of England ran the whole show under the graces of Gold. Care to guess how much Gold the Bank of England had in its vaults during the nineteenth century? During the ‘peacable days’? It was not the 8,000 Tons that Uncle Sam has… not the 3,000 Tons that Germany has… no, it was an incredibly tiny 150 to 250 Tons…
This number is in the public records of the Bank of England… if you doubt me, check it your self. The commerce of practically the whole world was well conducted on the basis of a few hundred Tons of gold. Where was the rest of the Gold? Where were the thousands of Tons that were in existence? Why, in the hands of average people; Gold was in circulation as money. Guess Who Made the Rules?
It was every man who made the rules, not a handful of banksters and G’men. But how… how could hundreds of millions of men, nay billions of men make any rules? The answer is laughably simple, once you see the truth. The rule for setting interest rates works like this;
When I earn money, there are only three things I can do with it; spend it, hoard it, or put it to work to earn more money… somehow. There is no other possibility… if you concede that giving money away as a gift is spending. Some spending is mandatory… as I need to buy food, fuel, shelter, clothing… the essentials. Hoarding and ‘saving’ are optional.
Hoarding has some less unpleasant connotations; we are constantly being told that hoarding is somehow wrong, anti-social, ‘primitive’… like a Gold standard is called ‘primitive’… but even squirrels have enough brains to hoard, saving food in balmy summer days to last them through the tough winter days to come. Are humans as smart as squirrels?
As far as putting money to work, only entrepreneurs and businessmen truly put their money to work. Average, ordinary people are far too busy earning a living to go into business for themselves. Instead, they look for ‘yield’ with ‘safety’.
This is impossible under Fiat paper… as we already saw. There are no real returns possible without all-out gambling, er speculation. Under Gold, the story is very different. After all, simply hoarding Gold is profitable. The purchasing power of a Gold hoard increases as prices decline. Any earnings from lending money at interest are a bonus.
I would not lend my Gold money… unless I was absolutely certain of getting it back, and was offered sufficient interest income. If you get Gold money, would you not think the same way? Spend some, hoard some… but only lend some if the interest being offered was sufficient to make it worth your while?
I believe you think the same way, although what you consider ‘worth your while’ may not be the same as what I consider ‘worth my while’. Nevertheless, this is the crux of the matter; this is where the rubber meets the road.
If hundreds of millions of people think the same way… that is, choose NOT to lend their money unless they believe it ‘worth their while’… then anyone who wants to borrow must offer more interest. The ones who hold the Gold make the rules. Borrowers must follow the rules set by the Gold holders, or they luck out.
With paper this does not work; the ‘powers that be’ will simply print up more paper, and force rates down… regardless of what I, or what you, or what a hundred million others wish for.
This is why only a true Gold Coin standard can work; actual Gold must be in circulation, in the hands of all… else the teeth are not there. No monetary system with Gold ‘backed’ (paper) money can ever work. If fraudulent paper is in circulation, and if fraudulent paper is accepted as money, more fraudulent paper will be printed… regardless of promises of ‘backing’ Indeed, Mr. Bankster may open the door to his vault, show us the Gold sitting there ‘backing’ our paper… and then print as much paper as he wishes… but he cannot print Gold.
Articles:Editorial, News, A Strong Dollar Is Not A Healthy Dollar!, The American Corner: How Do They Force People to Participate in the Dollar Scheme?, But there is not enough Gold…is there?, Theory of Interest and Prices in Paper Currency Part IV (Rising Cycle)