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The American Corner: The Credit Gradient

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(Extracted from the August edition of our monthly journal: The Gold Standard)

The United States, and every country, is subject to a monetary authority and legal tender laws. Here in the U.S. we have the Federal Reserve, a central bank that plans money and credit. The Fed thought they had perfected their planning (but of course it cannot be perfected). They thought they had ended the boom and bust cycle, and brought us into a brave new era, their so-called great moderation that ended in 2008. All they really did was manage the banking system to the brink of insolvency.

Let’s try a thought experiment. Suppose the monetary central planner attempts to fix the problem of insolvency by massive injections of liquidity. The central bank buys bonds. It dictates rates near zero on the short end of the yield curve, and promises not to raise rates for years to come. What perverse outcome would we expect?

Arbitrageurs see a green light, telling them that they can safely borrow short to buy long bonds. As the price of a bond goes up, the rate of interest goes down—it’s a rigid mathematical inverse. This is how suppression of short-term rates causes suppression of long-term rates.

This poses a problem for investors. Every investor has a minimum yield he must earn in order to meet his goals, such as retirement. When the yield available in government bonds falls, this gives the investor a strong push to other bonds with higher yields. Some Treasury bond owners sell, and go into AAA corporate bonds. This, of course, pushes up bond prices and pushes down the yield. This pushes some AAA corporate investors into AA bonds. And so on.

The net yield earned by every investor is pushed lower. However, at each step in the process, the effect is diminished. The wave of credit does not quite make it all the way to the other side of the pool, where the small businesses are trying to get wet.

In a free or semi-free market, credit is generally plentiful and inexpensive for mature, large enterprises. When well managed, these companies offer a low credit risk. Conversely, it has always been difficult for startups to obtain credit. When they can get it, they have to pay dearly. In other words, there is a credit gradient.

A gradient describes a change in concentration of something as you move through a range of coordinates. For example, this is a color gradient.

 Screen Shot 2014-08-27 at 09.19.48

Of course, there is always a credit gradient. Only now, the Federal Reserve has exaggerated it to an extreme. They have made the gradient steeper.

The biggest players are drunk, chugging as much as they want. At the same time, the scrappy disruptors with the greatest opportunities to improve our world are more dehydrated than ever. Worse yet, the innovators have to try to compete for resources with the large corporations.

The credit gradient is artificially enhanced. The end result is not surprising.

I came across this paper, by the Brookings Institute. Authors Ian Hathaway and Robert Litan found that “Like the population, the business sector of the U.S. economy is aging. … The share of firms aged 16 years or more was 23 percent in 1992, but leaped to 34 percent by 2011—an increase of 50 percent in two decades.”

Entrepreneurial young companies are not hiring, or in many cases, surviving. The older, larger ones are all that remain. Their hiring is anemic compared to that of younger companies. The proof is in the labor force participation rate, which shows the percentage of working age people who are employed or seeking employment. It is now down to a level last seen during the Carter Administration in the late 1970’s.

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Although there are other factors that contribute to this dismal reality including minimum wage and labor law, taxes, environmentalism, subsidies for crony companies, and regulations, the artificially enhanced credit gradient deserves the lion’s share of the blame.

Keith Weiner – President the Gold Standard Institute US

America Needs The Gold Standard More Than Ever

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Republished from Forbes Magazine:

http://www.forbes.com/sites/keithweiner/2014/06/24/america-needs-the-gold-standard-more-than-ever/

The godfather of modern economics, John Maynard Keynes, dismissed the concept of gold as money—the gold standard—as a “barbarous relic.” Another economics titan, Nobel Prize-winner Milton Friedman, conceded that gold is good in theory, but opposed gold in practice, arguing that a return to a gold standard is “neither desirable nor feasible.”

Both Keynes on the left and Friedman on the right got it really, horribly wrong.

The gold standard is neither barbaric nor impractical, and it is more urgently needed every day. This is because the standard of paper money is failing. It has set in motion an accelerating series of crises, each worse than the previous. The nation cannot continue to borrow to infinity, nor can the U.S. endure zero interest much longer.

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Campaign poster showing William McKinley holding U.S. flag and standing on gold coin “sound money”, held up by group of men, in front of ships “commerce” and factories “civilization”. (Photo credit: Wikipedia)

An examination of history supports the case for gold. Under the gold standard in the 19th century, the quality of life of most people improved faster than ever before, or since. It didn’t last because, unfortunately after the turn of the century, war preparations required huge expenditures.

Waging what was later called the Great War could only be financed by one means: debt. And there was only one way to borrow. In most countries, a central bank was already established, and by 1913 even the freest country had created a central bank. They called it the Federal Reserve.

Central banking is simply central planning—government interventions—applied to money and credit. The gold standard is simply a free market in money. Intervention conflicts with a free market, and gold lost the battle. It’s no coincidence that economies collapsed one by one after the war.

All too soon, men were marched off to war again. By the end, much of the world was reduced to rubble and desperate political leaders sought credit to finance postwar reconstruction. The U.S. named its terms: other countries had to treat the U.S. dollar as if it were gold. The Allies signed the treaty, at Bretton Woods in New Hampshire.

But the U.S. dollar was not as good as gold. It was merely Uncle Sam’s promissory note. Perversely, the greater the world’s demand for money, the more debt the U.S. government could issue, which enabled more spending. The crisis came to a climax in 1971, when President Nixon’s gold default created the current system. By Nixon’s decree, the dollar became an empty promise, backed by literally nothing.

Since then, we have had a worldwide regime of irredeemable fiat money. Debt has exploded, doubling about every eight years. The interest rate skyrocketed until 1981, and then went into free fall. The financial system will soon collapse, though when is hard to predict.

Gold, because it empowers savers to keep debt and interest in bounds, can prevent catastrophe.

The main argument against gold is that we need loose monetary policy to get out of recessions. The crisis of 2008 debunks this. Our monetary planners didn’t see the crash coming, and their short-term patches—stimulus and bailouts—have fixed nothing. The next crash looms.

The practical argument against gold is that we don’t have enough of it. This is simply untrue. The 19th century gold standard was run with just a few hundred tons of the metal in London, a tiny fraction of what the US has today. The argument is also frivolous. If the market is allowed to set the value of gold, no particular quantity is necessary.

There is also an argument against a lone country adopting gold. Currency devaluation encourages exports, lifting employment and the economy. It is true, so far as it goes. A falling currency cheapens export goods in world markets. But to fixate on this point ignores destruction of business capital and rising cost of imports, including raw materials. Japan’s economic history confirms this. The yen rose along with exports for decades. Since 2012, the yen has fallen. Japan’s balance of trade is falling with it.

Everyone is better off under gold. Even if other countries remain tethered to failing paper currencies, America should adopt the gold standard. Stable money will allow Americans to thrive. A major component of prosperity is the discipline gold imposes on government spending.

Keynes was wrong that gold is barbarous. Indeed, without gold, the world is now careening toward barbarism. Friedman was wrong that gold is impractical and the West’s teetering economy proves it. What we need more than ever, with the U.S. leading the world, is a path toward adopting gold as money.

Keith Weiner – President the Gold Standard Institute US

The Lazy 1970’s vs. the Frenetic 2000’s

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by Keith Weiner

 

Many people today see the Fed’s Quantitative Easing as money printing. They remember what happened in the 1970’s, and they instantly jump to conclusions. However, we live in a different world. To illustrate this, consider the following story about Joe, a promising and eager young manager in a struggling manufacturing company.

 

Joe excitedly walks into the boardroom and pitches his idea. “Let’s borrow a billion dollars. We can use it to build a massive warehouse and to buy massive quantities of our raw materials!”

 

The senior management team stares at him. The CEO demands, “Why?”

 

“We need to have a stockpile at every level. We should start with 3 months of raw materials, and a three-month buffer of work-in-progress in between every one of the 27 steps of our manufacturing line. And even better, we need to warehouse finished product. We shouldn’t ship anything that hasn’t been sitting for at least 4 months. Ideally six, but we can start with four.” Joe has the bit in his teeth now.

 

He rushes on. “Bernanke has printed so much money, and Yellen is going to continue. We already have massive inflation and it’s going to get worse! By borrowing to buy stuff that is only going up in price, we can make extra profits and protect ourselves from supply shocks as the cost of commodities rises out of sight!”

 

The CFO leans over to whisper in the ear of a young assistant, Bill. Bill does a quick Google search and finds the price of copper, which is one of the most important raw materials the company buys. Bill puts the copper chart up on the screen. It has fallen a third over the past few years.

 

Joe will be lucky to remain employed when he leaves the room. To be fair to him, his mistake is simply to try to implement a business strategy around what most casual observers and many economists believe.

 

Sometimes, the best way to debunk an idea is to take it seriously.

 

Though it makes no sense today, holding inventory was not the crazy idea of a young fool back in the 1970’s. It was how many businesses conducted business. In that era, the game was to accumulate inventories. The more, the better. First people were trading excess cash for inventories. I can recall my parents stockpiling things like canned tuna fish. It was better to keep one’s wealth stored in a durable food product than in a bank account. Consumer prices were rising about 20 percent per year.

 

Next, companies began selling bonds to finance inventory growth. This pushes down the bond price, which is the same thing as pushing up the interest rate. And of course it pushes up prices.

 

In the 1970’s, cash was trash. Inventories rose relentlessly in value, at least as measured in terms of the dollar. This, by the way, is a great example of how irredeemable money distorts the economy. You aren’t producing any more, or creating any kind of new wealth, and yet, you are rewarded with a profit.

 

Now we have the opposite condition. Since the interest rate began falling in the early 1980’s, companies have been finding ways to reduce inventory accumulation. The Lean manufacturing movement began to gain acceptance at this time. Lean, also known as the Toyota Way, defines inventory—such as work-in-progress sitting on a shelf—as waste. Lean is all about eliminating waste.

 

Today, cash is king. Excess inventory quickly becomes obsolete.

 

Companies are not borrowing to hold inventory, but to expand production when they can make a profit above the cost of capital. Since the interest rate keeps falling, the hurdle to get over for minimum acceptable profit keeps going lower.

 

Think of it this way, if you manufactured handheld electronic devices, would you want to keep inventory a minute longer than you had to? Of course not, because your competitor is about to release a new model that will make your product less desirable, or even unsalable. How about clothing? Cars?

 

In the 1970’s, the interest rate was rising. When a worn-out plant needed replacing, it may not have been feasible to borrow to replace it. That’s because the new interest rate was much higher than at the time when the plant was first acquired, a decade or more earlier.

 

This is the connection between the rate of interest and the rate of profit. It’s impossible to borrow at a higher rate than the profit one hopes to earn. A rising rate will therefore lead to rising margins, and a falling rate to falling margins.

 

Other than the problem of financing plant replacement, business was easy. Sleepy conglomerates had travel policies that allowed managers and executives to fly first class, even for domestic travel. With the cost of borrowing rising all the time, profit margins were expanding. And there was the kicker, holding inventory before selling it fattened margins further.

 

Business had a lazy pace to it, as I look at it today (though business managers at the time might not have agreed with that characterization).

 

In comparison, today it is the opposite. Limitless oceans of dirt-cheap credit issue forth, like effluent from the world’s central banks. The problem is not replacing worn-out plant when the cost of capital is higher. The problem is that every competitor has ever-cheaper cost of capital. The challenge is that rapid product cycles are driving rapid obsolescence. It is harder and harder to recoup design and tooling expenses. Inventory that sits for a week may have to be liquidated at a massive discount. Profit margins are under constant pressure.

 

Business executives routinely fly coach, even for international travel.

 

If the word for the 1970’s business environment was lazy, the word for today’s climate is frenetic.

 

Neither is the ideal behavior for a rational enterprise. They are the direct fault of the regime of irredeemable paper money.

 

Everyone’s attention is misdirected towards prices. Is the Consumer Price Index rising? Is it rising more than expected? How about the producer price index? Is that dropping into the dread D-word—deflation?

 

It’s the greatest economic sleight of hand ever perpetrated.

 

Instead of zeroing in on prices, we should be looking at the enormous distortions of our centrally banked irredeemable currency. We have bubbles, malinvestment, insolvencies, volatility, with exponentially rising debt and derivatives outstanding.

 

Theory of Interest and Prices in Paper Currency Part V (Falling Cycle)

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In Part I (http://keithweinereconomics.com/2013/04/22/theory-of-interest-and-prices-in-paper-currency-part-i-linearity/), we looked at the concepts of nonlinearity, dynamics, multivariate, state, and contiguity. We showed that whatever the relationship may be between prices and the money supply in irredeemable paper currency, it is not a simple matter of rising money supply rising prices.

In Part II (http://keithweinereconomics.com/2013/05/15/theory-of-interest-and-prices-in-paper-currency-part-ii-mechanics/), we discussed the mechanics of the formation of the bid price and ask price, the concepts of stocks and flows, and the central concept of arbitrage. We showed how arbitrage is the key to the money supply in the gold standard; miners add to the aboveground stocks of gold when the cost of producing an ounce of gold is less than the value of one ounce.

In 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.

“Brittle”.

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.

The Unadulterated Gold Standard, Part IV (Intro to Real Bills)

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Invoice

http://keithweiner.posterous.com

In Part I (http://keithweiner.posterous.com/unadulterated-gold-standard-part-i), we looked at the period prior to and during the time of what we now call the Classical Gold Standard. It should be underscored that it worked pretty darned well. Under this standard, the United States produced more wealth at a faster pace than any other country before, or since. There were problems; such as laws to fix prices, and regulations to force banks to buy government bonds, but they were not an essential property of the gold standard.

In Part II (http://keithweiner.posterous.com/unadulterated-gold-standard-part-ii), we went through the era of heavy-handed intrusion by governments all over the world, central planning by central banks, and some of the destructive consequences of their actions including the destabilized interest rate, foreign exchange rates, the Triffin dilemma with an irredeemable paper reserve currency, and the inevitable gold default by the US government which occurred in 1971.

In Part III (http://keithweiner.posterous.com/unadulterated-gold-standard-part-iii) we looked at the key features of the gold standard, emphasized the distinction between money (gold) and credit (everything else), and looked at bonds and the banking system including fractional reserves.

In this Part IV, we consider another kind of credit: the Real Bill. We must acknowledge that this topic is controversial because of the belief that Real Bills are inflationary. This author proposes that inflation should not be defined as an increase in the money supply per se, but of counterfeit credit (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit).

Let’s start by looking at the function served by the Real Bill: clearing. This is an age-old problem and a modern one as well. The early Medieval Fairs were large gatherings of merchants. Each would come with goods from his local area to trade for goods from other lands. None carried gold to make the purchases for two reasons. First, they didn’t have enough gold to buy the local goods plus the gross price of the foreign goods. Second, carrying gold was risky and dangerous.

The merchants could have attempted some sort of direct barter. But they would encounter the very problem that led to the discovery and use of money originally. It is called the “coincidence of wants”. One merchant may have had furs to sell and wants to buy silks. But the silk merchant does not want furs. He wants spices. The spice merchant may not want silks or furs, and so on. It would waste everyone’s time to run around and put together a three-way deal, much less a four-way or a 7-way deal so that every merchant got the goods he wanted to bring to his home market. They developed a system of “chits” to enable them to clear their various and complex trades. In the end, all merchants had to settle up only the net difference in gold or silver.

Clearing is necessary when merchants deal in large gross amounts with small net differences.

The same challenge occurs in the supply chain of consumer goods. Each business along the way adds some value to the product and passes it to the next business. For example the farmer starts the chain by selling wheat. The miller turns wheat into flour and sells it to the baker. The baker turns flour into bread and sells it to the consumer. These businesses run on thin margins, and this is a good thing for everyone (though the baker, the miller and the farmer might disagree!) The question is: on thin margins, how are they to pay for the gross price of their ingredients before selling their products?

This is an intractable problem and it only gets worse if they attempt to grow their businesses. Further, it would be impossible to add a new business into the supply chain. For example, a processor to bleach the flour might be a separate company. And then it may turn out that when the bakery grows and grows, that it is more efficient to operate a small number of very large regional bakeries and then the distributor enters the supply chain to buy the bread from the baker and sell it to another new entrant in the chain, the grocer.

With each new entrant into each supply chain, the supply of gold coins would have to grow proportionally. This is not possible. Fortunately, it is not necessary. If there were a means of clearing the market, then only the net differences would have to be settled in gold. If consumers buy 10,000 grams of gold worth of bread from the grocer, the grocer could keep his 5% profit of 500g and pass 9,500g to the distributor. The distributor would keep his 2% profit of 190g and pay 9310g to the baker. The baker would keep his 10%, 931g and pay 8379 to the flour bleacher, and so on up the chain.

The obvious challenge is that the payments move in the opposite direction compared to the goods. Whereas the wheat is eventually turned into bread as it moves from the farmer to the consumer, the gold moves from consumer to farmer. The Real Bill is the clearing mechanism that makes this possible.

Without the Real Bill, the enterprises in the supply chain would have to borrow using conventional loans and bonds, which is less efficient and more expensive. Or else the division of labor along with highly optimized specialty businesses would not be possible.

As we discussed in Part III of this series, everyone benefits if it is possible to efficiently exchange wealth in the form of savings for income in the form of interest on a bond. The saver’s money can work for him his whole life, and he can live on the interest in retirement without fear of outliving his money. The entrepreneur can start or grow a new business without having to spend his career saving a fraction of his wages, working a job in which he is underemployed. Everyone else gets the use of the entrepreneur’s new products, and thereby improve their lives.

The same analogy applies to the efficient clearing of the supply chain for every kind of consumer good. This is especially true as new entrants come in to the chain and make the process more efficient (i.e. less expensive to the consumer). And it is also necessary for seasonal demand, such as prior to Christmas. Clearly, there is an increase in the production of all kinds of consumer goods around September or October. Everything from chocolates to wrapping paper must be produced in larger quantities than at other times of the year. Without a clearing mechanism, without the Real Bill, the manufacturers would be forced to limit production based on their gold on hand. There would be shortages.

In practice, the Real Bill is nothing more than the invoice of the wholesaler on the retailer. In our example, the distributor delivers bread to the grocer and presents him with a bill. The grocer signs it, agreeing to pay 9500g of gold in 90 days (probably less for bread). It is an important criterion that Real Bills must be paid in less than 90 days, for a number of reasons. First, the Real Bill is for consumer goods with known demand. If the good does not sell through in 90 days, that indicates a problem has occurred or someone has misestimated the demand. The sooner this is realized, the better.

Second, 90 days represents the change of the season in most countries. What had been in demand last season may not be in demand in the next.

Third, the Real Bill is a short-term credit instrument that is not debt. At the Medieval Fair, there was no borrowing and no lending. The same is true for the Real Bill. The wholesaler does not lend money to the retailer. He delivers the goods and accepts that he will be paid when the goods sell through to the consumer. The retailer agrees to pay for the goods when they sell through, but he does not borrow money.

Finally, if a business transaction requires longer-term credit, then it is appropriate to borrow money via a loan or a bond. The Real Bill is not suitable for the risk or the duration. Longer-term credit means that it is not simply being used to clear a transaction, but that there is some element of speculation, storage, and uncertainty.

What has happened in different times and in different countries is that Real Bills circulate. Spontaneously. No law is required to force anyone to accept them. No banking system is necessary to make them liquid. Real Bills “circulate on their own wings and under their own steam” in the words of Antal Fekete1. The Real Bill is the highest quality earning asset, and the highest quality asset aside from gold itself (incidentally, this is why Real Bills don’t work under irredeemable paper—it would be a contradiction for a Real Bill to mature into a lower-quality paper instrument).

Opponents of Real Bills have a dilemma. They can either oppose them by means of enacting a coercive law, or they can allow them because they will spring into existence and circulate in a free market under the gold standard. We can hope that the principle of freedom and free markets leads everyone to the latter.

It is not the job of government to outlaw everything that experts in every field believe will lead to calamity. And those experts should be cautious before prejudging free actors in a free market and presuming that they will hurt themselves if left alone.

In Part V, we will take a deeper look at the Real Bills market, including the arbitrages and the players…

© Keith Weiner, Jan 10, 2013

Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

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